How correlation trading works
Correlation measures how two assets move relative to each other, on a scale from +1 to -1. A correlation of +1 means they move together, -1 means they move opposite, and 0 means no relationship. Correlation trading uses these links: pairing assets that move together, hedging with assets that move opposite, or betting that an unusual divergence between two related markets will snap back.
Worked example
Two oil majors normally move together with a correlation near +0.9. One day company A jumps on news while company B lags, opening an unusual gap. A correlation trader might buy B and short A, betting the historical relationship reasserts and the gap closes, profiting from the convergence regardless of where oil itself goes. The risk is that the correlation has genuinely broken, not just stretched.
Why correlation matters for risk
Correlation is also a hidden risk in any portfolio: holding five highly correlated positions is really one big bet, because they will all fall together in a shock. On Volity, checking correlation before stacking trades keeps you from doubling risk by accident, and lets you hedge a long book with a negatively correlated instrument. Diversification only works when correlations are low.
Why it matters
Correlation decides whether your positions diversify your risk or secretly concentrate it, which is why a portfolio that looks varied can crater as one. Measure it before sizing, and treat correlated trades as a single exposure. Related: drawdown and hedging.
Learn more in our forex trading guide.
