Correlation and Portfolio Heat
Measure total open risk and avoid hidden concentration when several trades depend on the same driver.
What you will learn
- What correlation means for open trades.
- How to calculate portfolio heat (total open risk).
- How to group trades that share a common driver.
- How to set limits for total and grouped risk.
Explanation
Correlation describes how two prices tend to move together. The correlation coefficient ranges from −1 (they move in opposite directions) through 0 (no consistent relationship) to +1 (they move in the same direction). It is measured on past data. It changes over time and often rises in stressful markets, when many assets fall together.
If you buy EUR/USD and GBP/USD and sell USD/CHF, you hold three trades, but they share one main driver: the US dollar. A strong dollar move can stop out all three on the same day. In practice they behave like one big trade.
Portfolio heat is the sum of the planned risk on all open positions, in euros or as a percentage of the account. If a stop has been moved to break-even, that position's planned risk is zero, although gap risk remains.
A risk policy usually has two limits: a maximum total heat (for example 4% of the account) and a maximum per group of related trades (for example 2%). Groups can be built around a currency, a sector, an index, or "risk-on" assets such as shares and crypto. These numbers are examples; choose your own and write them down.
Worked example
Hypothetical example: account €10,000, 1% (€100) risk per trade. Policy: maximum heat 4% (€400), maximum per group 2% (€200). Fees and gap risk are excluded.
| Position | Main driver | Planned risk |
|---|---|---|
| Long EUR/USD | Weak USD | €100 |
| Long GBP/USD | Weak USD | €100 |
| Short USD/CHF | Weak USD | €100 |
| Long index CFD | Stocks rising | €100 |
| Long gold | Gold rising | €50 |
- Total heat = €100 + €100 + €100 + €100 + €50 = €450 = 4.5%. This is above the 4% limit.
- "Weak USD" group = €300 = 3%, above the 2% group limit.
- Fix: reduce each USD trade to about €66 (group ≈ €200), or close one of them. Total heat then falls to about €350 = 3.5%.
Note that gold is often influenced by the dollar too. A careful trader might count it in the dollar group as well.
Common mistake
Practice activity
Account €20,000, risk 0.75% per trade. Open positions: long three technology shares, long a technology-heavy index CFD, long EUR/JPY, each at full risk. Policy: total heat maximum 4%, group maximum 1.5%. Calculate total heat, the technology group risk, and whether you are within your limits.
Show solution
Risk per trade = 0.75% × €20,000 = €150.
Total heat = 5 × €150 = €750 = 3.75%, within 4%.
Technology group = 4 × €150 = €600 = 3%, double the 1.5% (€300) limit. Reduce to two full positions or four half-size positions.
Limitations: correlation is historical and unstable; the grouping is a judgement, not an exact measurement.
Key takeaways
- Trades driven by the same factor act like one larger trade.
- Portfolio heat is the sum of planned risk on open positions.
- Set limits for total heat and for each group of related trades.
- Correlation can rise sharply when markets are stressed.
Next step
The next lesson looks at losing streaks and drawdowns, and how to limit damage when results turn against you.
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