Highly Correlated Markets: New Rule Explained

I thought I'd give a little more explanation for a new rule I adopted a couple of weeks ago on how to manage signals in highly correlated markets when they contradict each other. What to do when my silver setup goes short while gold remains long? Am I betting against myself by taking both signals? I've ordinarily traded all such signals without hesitation and ultimately think that's the best way to take advantage of the full potential for each setup. As Curtis Faith pointed out in his classic Way of the Turtle, you never know which signal will be the one that lifts your portfolio into orbit, so you must follow each trade with discipline.

But as I'm still refining my system, I wanted to temporarily adopt a risk-control rule for these situations. The rule works like this: If I get a signal from a setup, I check what my other setups are doing in markets that are highly correlated. If the majority of signals agrees, I take the trade. If not, I ignore the signal. For example, if my BKX Bank Index setup says to go long for Monday, May 19, I check my setups for the two markets that are highly correlated to BKX - the Dow Jones industrials and Russell 2000. I take the BKX trade if at least one of those is also bullish or will be bullish as of May 19.

Below you'll find a table of highly correlated markets. I defined markets as "highly correlated" when their weekly open prices have greater than 0.85 correlation between March 1995 (the start of the combined futures and options Commitments of Traders data) and the end of 2007 (the end of my test data). This new rule is somewhat of a work in progress and will no doubt evolve as I continue to refine my setups. On that score, I've been getting promising results from out-of-sample testing for my setups and revisiting my setups in order to account for trading friction (i.e., commissions) and recent performance during the bull market. I'm also getting some great results from examining new setups based on combining the signals from two trader groups or two different parameter values for the same trader group. Stay tuned.

Highly Correlated Markets Table

S&P 500: Dow Jones industrials
Dow Jones industrials: BKX Banks Index and Russell 2000
Russell 2000: BKX Banks Index and Dow Jones industrials
NASDAQ 100: n/a
BKX Bank Index: Dow Jones industrials and Russell 2000
Nikkei: n/a
Natural gas: n/a
Gold, copper, silver, platinum, heating oil, crude oil (all highly correlated with each other)

Notes:
1) Markets like the Nikkei and NASDAQ 100 that have the notation "n/a" aren't highly correlated with any other market. Incidentally, I think these uncorrelated markets are great for building diversity into my portfolio.
2) No trade will be taken in the case of an equal number of long and short setups in highly correlated markets.