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The FX market is immense. There are seven major FX pairs and over 70 crosses! How can one person possibly keep track of everything and identify the best pairs to trade at any given time? That's where the correlation matrix can come in handy.

Most traders, when exposed to the word “correlation”, automatically think of intermarket analysis.

For example:

Setting Up Your FX Correlation Matrix

It is very easy to manually determine a correlation matrix in MT4 and MT5.

  1. Select your currency pairs to compare.
  2. Select the time frame based on your trading style:

Of course, these are only suggestions. The key is to select a time frame and a lookback period that compliments your trading style and commit to it.

  1. Highlight the strong correlations that are visible. Identify which pairs are either moving strongly in lockstep or strongly opposite one another.
  2. Determine what market event is enacting a similar influence over the different currency pairs.
correlation matrix

Alternatively, custom indicators can be added to your account to do some of the heavy lifting for you.

Tracking Common FX Themes

When all the crosses of a currency pair are moving in the same direction, there is usually a fundamental reason. Even if you don't know the fundamental cause, you can still identify the overwhelming dynamic and keep that currency pair on your watch list.

Using Correlations To Allocate Risk

When correlations are high, you can spread your risk capital amongst two or three different FX pairs. This way, you reduce the risk of identifying the market drivers correctly but on the wrong instrument. We will never know ahead of time which pair will be “the winning horse”. Consequently, when there is a strong correlation amongst crosses, splitting our risk allocation amongst two or three candidates makes more sense. We can then ride the winning horse and reduce risk on the slower performers.

It's already difficult enough to identify clear drivers and strong themes in the currency markets. If we think we're good enough to pick the best currency every time, we fall into yet another mental bias that will harm us more than help us. So, instead of risking, say 2%, on one single currency pair, try risking 0.5% on three pairs. As a result, one of them might develop into the multi-day trend trade we all aspire to catch.

What’s Next?

The correlation matrix is a very neat tool that allows us to spot strong FX correlations amongst the major pairs quickly and amongst the crosses of a given regional currency.

You should attempt to:

  1. Identify the situations that show high correlation amongst pairs.
  2. Track them back to the fundamental influences that are driving the correlation.

If you take these simple steps, you will be in an ideal situation. You will understand why the currencies are behaving the way they behave, and you will be able to make sense of the technical behaviour on your charts.

It's like boxing with both arms (technical and fundamental) instead of just one (technical).

The First Rule of Trading Forex

Have you ever found that your trading system works great one day but fails miserably the next? If so, your problem is likely market-type identification.

Too many forex traders will trade the same way no matter how the market is behaving. Instead, you should identify the market type first. Then, you can devise a strategy appropriate to that market type. Sounds simple, right?

With the proper technique and a little practice, you will be able to quickly tell what market type you’re in and how to trade it. There are six primary market types in forex that you need to be able to identify:

- Bull Normal
- Bull Volatile
- Bear Normal
- Bear Volatile
- Sideways Quiet
- Sideways Normal

If the market type is quiet, wait for a breakout or range trade. If the market type is bullish, look to buy dips. If it’s bearish, look to sell rallies.

When Market Types Change

Like the weather, market types shift and change. The good news is they do so in a predictable manner. Volatile market types settle into normal then quiet markets. Bull markets turn sideways before they turn bear, and quiet markets expand into trending bull or bear markets. As a trader, you want to be aware of what market typically comes next and plan accordingly.

How to Identify Market Types

While there are numerous ways to identify market types, here is an intuitive model you can follow.

For this, we use two sets of indicators:

- Bollinger bands
- A 7-period and a 3-period Exponential Moving Average (EMA)

These can be applied across any timeframe on any chart. They provide you with an easy-to-use method of identifying the current market type.

Bull Normal Market Types

A bull normal market type can be identified by the price trading above the Bollinger band, while the 3-period moving average is trading above the 7-period.

The Strategy

In a bull normal market type, there are generally two strategies that will be effective:

  1. Buying dips. You set limit orders at key levels or wait for a pull-back. This is an indication that the trend is going to continue.
  2. Buying breakouts. You wait for periods of consolidation and then buy breakouts in the direction of the trend.

Bull Volatile Market Types

bull market volatile

Bull volatile market types can be identified by large candles trading above the Bollinger bands. These candles will often have long wicks.

The Strategy 

In volatile bull market types, it can be tempting to rush in and buy. However, this may not always be the best course of action. Keep in mind that prices can quickly reverse. If you are lucky enough to be in a position that turns into a volatile bull, then keep your stops tight.

Bear Normal Market Types

Bear normal market types can be identified by the price trading below or along with the lower Bollinger band and the 3-period moving average remaining below the 7-period.

bear market normal

The strategy 

For a bull normal market type, sell on rallies or breakouts after a period of consolidation.

Bear Volatile Market Types

Bear volatile market types can be identified by the large candles trading outside of the Bollinger band.

The strategy

Similar to the bull volatile market type, the bear volatile market type is a difficult one for entries. However, if you find yourself in one, as you often will, keep your stops tight to guard against the reversal. This will allow you to capture profit if the move continues. It will also allow you to keep hold of most of your profits if it quickly reverses.

Sideways Quiet Market Types

You can identify a sideways quiet market type by the Bollinger Bands tightly coiling around the price.

sideways quiet market

The Strategy

Breakouts from sideways quiet market types can provide excellent risk/ reward trading opportunities. Be patient and stalk the breakout like a hunter stalking their prey.

Sideways Volatile Market Types

Sideways volatile market types can be identified by expanded Bollinger bands moving sideways and the price contained within the range.

The strategy

There are some excellent trading opportunities for range trades during sideways volatile market types. Wait for the edge of the range to be penetrated and the price to reverse back inside before you place the trade.

What’s next?

Learning to identify the market type and apply the right strategy will significantly impact your trading.

Now, take out your trading plan and note:

  1. How you will identify the market type
  2. How you will trade it

Once you turn these notes into regular habits, you should start seeing better results.

The 5 Types of Forex Traders

There are 5 types of Forex Traders. These traders are separated by their trading style, risk profile, and trading objectives.

The Day Trader

Marty Schwartz's trading was at one time accounting for 10% of the daily volume on the S&P 500 futures contract. He is the author of "Pit-bull, Lessons from Wall St's Champion Trader".

To the uninitiated, the day trader may seem like a person of action. But they are just as comfortable stalking their trade as they are decisive when it comes time to execute. Typically surrounded by multiple screens, the day trader monitors dozens of inputs while waiting for a trade with an edge to appear.

Some trade rapidly, moving in and out of the market in a heartbeat, taking 5 pips here, 10 pips there. Others may be more serene, placing only one or two trades per session, carefully waiting for the optimal time to catch the day's move. The day trader may be boisterous and rowdy, but they have learned to separate their ego from the trade.

What if the market doesn't go for them? They either out or going back the other way. To the day trader, it's all the same. What matters is whether they cut their losses short or let their profits run. Whether they are right or wrong is irrelevant. They may only win with half of their trades. But through superior risk management, they end each day well in the black.

The Technical Analysis Trader

William Delbert Gann was famous for his ability to forecast market moves using technical analysis.

The charts weave a compelling story to the technician. They know that technical patterns provide a window into the market's soul and a snapshot of its psychology. It is through technical analysis that they surf the waves of market participants' fear and greed. Be it Fibonacci, Elliot Wave, or Gann theory; the technical analyst has the tools to help them predict the market's near-future. The skills to implement a winning trade are based on their ideas.

The technician can analyse both short and long-term moves. Some will combine their technical analysis with fundamentals, trading primarily when both are in alignment. Others trust the price. They trade first and seek reasons later.

The technician's charts are brightly adorned with trend lines, moving averages, stochastics and MACD. But underneath it, all is a beautiful simplicity that guides them to trade with accuracy and aplomb.

The System Trader

Ed Seykota is a system trader beyond compare. He understands that trading is about psychology first and the system second.

The system trader is the god of the trading machines. Through a rigorous process of development and testing, the system trader has automated their trading strategies. Their computer essentially does the trading for them. A picture of discipline, the system trader, sits calmly through rough periods. They know that when the trends appear, their profits will be significant.

System traders are in a research war. Markets change, and as they do, systems need to adapt. System traders spend more time researching than trading. That is unless they are roaming the world, as the master system trader is prone to do. His machines afford him the luxury of free time.

The Macro Trader

Famous for predicting the Black Monday crash in 1987, the billionaire Paul Tudor Jones is now the head of the philanthropic Robin Hood Foundation. The Global Macro Whizz Kid is known for trading big market moves with skill and tenacity.

The best global Forex traders know that it's hard work and discipline that has led to their success. They search tirelessly for opportunities in currencies, indexes, and commodities. Then, they work even harder to ensure the best risk/reward profile for their trade. They understand that ideas are only going to get them so far and that implementation is the key.

The best global macro traders (the true whizz kids) never have a losing year, profiting in all market types.

The Hedge Fund Trader

Ray Dalio is the founder of the world's largest hedge fund, Bridgewater Associates. In 2012, Dalio appeared on the annual Time 100 list of the 100 most influential people in the world and is currently worth over $15.2 billion.

It takes a leader to build a successful hedge fund, but it takes true leadership to build a business based on its people. Hedge funds are experts in selecting traders who fit their criteria, be they mechanical, macro or quant.

First and foremost, they are risk managers, with each trader having their place in a greater risk management plan. Traders that are performing exceptionally well are allocated more funds, while allocations are cut to those that are not.

The hedge funds trader knows that their team can produce returns far greater than their individual parts' sums.