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On Monday, a piece by Tim Mazanec was posted with the title Opportunity forthcoming? In the post Tim talks about how many very experienced people see EUR/USD at an important inflection point, that once the current range is broken the market will take off on a big new trend. It’s an easy call to make when a market is ranging, of course. It’s trickier not to get caught by a fake-out break-out.

That’s not really what I want to focus on, however. Rather I’d like to take a look at Tim’s observation that “…when risk is ‘on’ then both major industrialized stock markets and the Euro tend to do well”. To be more clear, when the market is in a risk-taking mood, underlined by stocks rallying, EUR/USD has a habit of rising. Since stocks and EUR/USD have been diverging of late, Tim sees this as a good opportunity for a mean reversion type of trade where the two markets get back in synch. I’ll put aside for the minute the fact that stocks could fall to get the two markets back in line rather than EUR/USD rising, and will instead focus on the correlations between the two markets.

First, take a look at this chart of the S&P 500 and EUR/USD going back to the middle of 2007 (basically when things started coming unglued). The stock index is the red line on the left scale, while the currency pair is the black line on the right scale.

We can observe that over significant periods the S&P and EUR/USD have in fact traded in parallel fashion. The most notable period was from mid-2008 to about March 2009 when both were trading sharply lower during the strongest part of the risk aversion period. The correlation was positive from those March lows last year through the end of the year, but a bit less so. Things started breaking down in the early part of 2010 when the two markets were on split courses like they were during the period from mid-2007 to mid-2008.

The following chart actually takes a more specific look at the correlation. It shows a rolling 1-month correlation between the S&P 500 and EUR/USD. By that I mean it plots the correlation of the two over the past 22 trading days, which is approximately one month worth of trading.

Notice how the correlation tends to cycle up and down. During the latter part of 2007 and into the middle of 2008 it was more often in the negative zone, while from mid-2008 to the end of 2009 it was more positive. In 2010 so far it has been strongly on both sides of the equation, most recently strongly positive but looking like it’s turning back down again based on the latest data. Notice that even when there is a bias for positive or negative correlations there are also numerous periods where the correlation flips the other way for a while. In other words, it can be dangerous for a short-term trader to rely on correlations to persist. They can change very quickly.

The two charts above tend of confirm Tim’s view that the S&P 500 and EUR/USD have generally been positively correlated during “risk on” periods. That was the way things played out during the bulk of 2009. They also show, however, that this year things have been different. The whole “risk on” correlation is not nearly as consistent, which suggests to me that things have changed on a fundamental basis.

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results.

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.