Market correlation can be a great asset to anyone's stock trading portfolio. It is crucial to know which markets and asset classes work best together for high reward and low risk opportunities. Just because two markets coincide with each other often, this does not make it suitable to use as correlation for upcoming trades. In this article I will discuss the leading indicator and how it can benefit you when trading stocks.
There is only one thing that causes the markets to move in any given direction (up, down and/or sideways) which is order flow. Order flow can be defined in many different ways but for this article we will refer to it as any order that is placed on an exchange to buy or sell an instrument. The common law of the financial market's equilibrium dictates that whomever has the most orders wins.
The institutions predominately control the markets due to the amount of liquidity they hold and trade. With large amounts of liquidity the institutions look to the futures markets as the best place to place their trades because there are a lot of willing buyers and sellers along with the fact they are open almost 24 hours per day. This combined with the fact that stocks close overnight offering no way of displaying the data for any given instrument makes the futures markets the leading indicator.
Using Futures as the Leading Indicator for Picking Stocks:
In the US markets the ES (S&P 500) futures are commonly looked to for direction of US based equities. When trying to choose a stock that has a higher probability of direction (whether up or down), it may be compared to the ES for correlation purposes and to help add probability in your favor for success.
How Does Market Correlation Work?
Let's take a look at how this works; Most will have a plethora of equities that they prefer to trade known as their stock portfolio. When looking at a stock portfolio the decision must be made whether to buy or sell any of the individual equities within the portfolio at any given time and statistically speaking, in most cases it will be to buy in the hopes of going higher. If the decision is to find a stock that has a high probability of going higher looking to the ES will be the first step. The direction of the futures market will tell you more information about your stock because it is comparing it to many other stocks at the same time.
Let's say the ES is declining during pre market trading, yet your stock that you have interest in purchasing is going sideways or even up. This tells us that your stock is stronger than many other stocks because the average of the 500 stocks in the S&P are declining. This is an indication that you have chosen a great stock for purchasing so when the futures market turns back up there tends to be even more momentum added into your individual stock.
The opposite also holds true; if you have chosen a stock to purchase in the hopes of going higher the first thing to check is the correlation between your stock and the futures market. If the futures are inclining during pre market trading while your stock is declining, this would indicate that your chosen stock is weaker than the average of equities in the S&P 500 and therefore not a good value. Once you have determined the appropriate stock to purchase based on the correlation probability factor, the final step is to apply your trading strategy for entry and exit.
The Bottom Line
Just like anything in trading we are looking for probability from the larger money to produce market turning points as well as continuation. Our trading strategy is based solely on the institutional supply and demand (order flow) by utilizing a very definitive approach to zone theory.