Trading Correlated Instruments - Futures How-to

Price correlation among instruments in the futures market is common and can be utilized to provide a closer look at which instruments may be leading or lagging in price. A prominent example is the U.S. Index Futures, comprising the S&P 500 (ES), Nasdaq-100 (NQ), Russell 2000 (RTY), and the Dow-30 (YM).

If you chart these indices, you'll find they share a correlated price pattern.

The price movement isn't identical, but very similar. By examining all four instruments simultaneously, we can determine possible market movement as a whole, as well as discrepancies in their individual prices as they correlate to each other. Most good entries occur quickly these days. With the prevalence of computerized trading, markets move rapidly, and good entries are seized in an instant – sometimes faster than the blink of an eye.

When analyzing correlated instruments, it aids us in deploying capital into areas where the market is likely to be most favorable toward our directional bias. I was taught this method by a proprietary trading firm: "Long the strong" or purchase the most bullish instrument among the correlated. Alternatively, it may make sense to short the laggard or most bearish instrument. It's a rule of thumb and nothing more. Markets often behave erratically, and shifts in the instrument leading or lagging frequently occur.

If we examine NQ, ES, and RTY together, primarily one of these will be leading in % change, whether positive or negative. While the three instruments are correlated and their price patterns chart similarly, one is usually most bullish or bearish. Day-traders, in particular, are not trying to keep large amounts of capital in the market but rather find profit opportunity and return to flat. As large institutional investors directionally drive the market, we look for longs on the strongest instrument and shorts on the weakest.

Though this technique can prove effective, long trades on the strongest index can still lose, and short trades on the weakest index can still lose. It's our priority as traders to analyze areas where the broad market may support our long on the strong or our short on the weak. When defining low-risk entries, we should combine multiple catalysts to increase our level of conviction toward our directional bias.

I'll conclude with a theoretical example. Let's assume the Nasdaq and S&P are both trending positive for the day, while the Russell is lagging slightly in negative territory. As the Nasdaq and S&P approach a possible point of buyer exhaustion, profit-taking, and short-seller entries, we can use this place of "resistance" to look toward a short entry on the already negative Russell. Since the Nasdaq and S&P are bullish and trending positive, a short on the already negative Russell may prove more effective than a short against a positive trend. The goal of this example would be to find a low-risk short entry on a negative instrument, with further confirmation of the directional bias by using areas where the positive instruments may temporarily reverse or break trend.

The break in trend of the positive indices, combined with a short entry on the negative instrument, may lead to an increased chance of profitability. This is a basic example, but the entire concept of this theory rests upon the idea that certain correlated instruments perform better or worse than others depending on the day. Our goal as traders is to find the discrepancy and capitalize on the strength or weakness at the current time. It's typically not a good idea to short into strong buying pressure or long into strong selling pressure, so we mitigate this risk by joining the consensus of the day based on the instrument itself and its relative strength in comparison to its correlated partners.

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Futures Trading is risky and not for everyone. You may lose all of your initial investment. Don't trade with money you can't afford to lose. The opinions discussed in this article are opinions. Use your own judgement and research to determine their validity.

Trade safely, with a plan, or don't trade at all.

-Josh