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Markets can become highly correlated for short periods of time. They become correlated very quickly based upon news that tends to affect the fundamental picture. The more you understand the fundamentals behind each market, the better you'll be able to understand how different markets can become correlated. It is fascinating to consider how markets become correlated, and to consider the implications of what one market is doing and how it might affect another market. For example, whenever I decide to place a trade in live cattle, I also monitor the price action in lean hogsprovided they are positively correlated. As soon as I see a price action in either live cattle or lean hogs that indicates it is time to enter into the trade, I do so. In some cases, for example, I want to get long in cattle, and yet the price action that I need to actually pull the trigger may not be present in cattle but will be present in hogs. If I had waited for the price action in cattle, I would have missed the trade. Studying market relationships is a truly fascinating endeavor. |
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It is important to remember that markets can become highly correlated (positive or negative) or uncorrelated very quickly for very short or very long periods of time. What determines this is the underlying news that causes the commodities to become correlated. The more that traders understand the fundamentals of each market, the more they begin to understand correlation factors. At certain periods of time interest rates/stocks, gold/crude bonds/stocks/crude, exchange rates/interest rates, crude/soybeans have all been either positively or negatively correlated. |
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Just as there can be a correlation factor between different markets, so there can be a correlation factor between the different methodologies a trader develops. When a trader diversifies on the basis of methodologies, it is crucial to use methodologies that are not correlated to each other. |
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Diversifying into different markets is the most common method by which a trader manages risk. As different markets that have little correlation are added to the portfolio, the amount of avoidable risk is reduced. The amount of avoidable and unavoidable risk reduction that is provided by trading three or four uncorrelated markets is very significant. The level of risk reduction continues to be reduced, albeit at a slower rate, until approximately eight uncorrelated contracts are being traded. According to most studies, diversifying into more than eight different markets is only slightly beneficial. |
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It is important that the markets diversified into have the same, if not better, liquidity. The benefits of increased diversification can easily be lost by using less liquid markets. In addition, as the number of markets that are traded increases, the more time the trader will have to spend studying these |
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