What is currency correlation in forex?
Currency correlation in Forex is a positive or negative relationship between two separate currency pairs. A positive correlation means that two currency pairs are moving in the same direction, and a negative one means that they are moving in opposite directions.
Correlations can open up opportunities for making more profit or be used to hedge positions in the Forex market and reduce risk. If you can be sure that one currency pair will move in parallel or against another, then you can either open another position to maximize your profit, or open another position to hedge the current position in case of increased volatility in the market.
However, if your forecasts when trading currency correlations turn out to be incorrect or if the markets move in an unexpected way, then you may incur more significant losses, or your hedging will be less effective than expected.
The strength of the currency correlation depends on the time of day and the current trading volumes in the markets for both currency pairs. For example, pairs that include the US dollar are often more active during the opening hours of the US market from 12 to 21 hours (British time), and pairs with the euro or pound sterling – from 8 to 16 hours (British time), when the European and British markets are open.
What is the correlation coefficient?
The correlation coefficient shows how strong or weak the correlation between two currency pairs is. Correlation coefficients are expressed in values and can be in the range from -100 to 100 or from -1 to 1, with the decimal fraction denoting the coefficient.
Any negative value in the range of -100 means that pairs move almost the same, but in opposite directions, and if it is greater than 100, it means that pairs move almost equally in one direction. “Almost the same” is an important difference, since the correlation takes into account only the direction, but not the magnitude. For example, one pair can move up by 100 points (percent per point), and the other pair can move down by 70 points. Both pairs can have a very high inverse correlation, even if the size of the movement is different.
If the readings are below -70 and above 70, then it is considered that the correlation is strong, since the movement of one pair largely affects the movement of the other. Readings in the range from -70 to 70, on the contrary, mean that the pairs are less correlated. With forex correlation coefficients close to zero, both pairs practically show no connection with each other.
Which currency pairs are correlated?
The key currency pairs that correlate most strongly with each other include such pairs as EUR/USD and GBP/USD, as shown above. They often move together due to the economic ties between the territories they represent.
In this case, GBP and EUR have a close relationship due to the geographical proximity of the Eurozone and the UK, as well as the status of the reserve currency. In addition, the fact that both of these pairs use the US dollar as a counter currency means that any change in the dollar exchange rate is reflected on both currency pairs simultaneously. It is shown below that the price lines tend to move in a similar way with each other.
Other pairs showing strong correlation are EUR/USD and AUD/USD, as well as EUR/USD and NZD/USD.
How to trade forex correlation pairs?
There are many ways to use correlations as part of a Forex trading strategy, for example, hedging, trading pairs and commodity correlations. To start trading correlation pairs on the Forex market, it is enough to perform the following actions:
- Open a real account. In addition, you can practice using virtual funds on our demo account.
- Study the Forex market. Expand your knowledge of currency pairs and what influences them, for example, inflation, interest rates and other economic data.
- Choose a currency correlation strategy. It is often useful to make a trading plan in advance.
- Explore our risk management tools, such as stop loss and take profit orders, which can be useful for managing risks in unstable markets. Remember that they don’t always protect you from market slippage or disruption.
- Place your deal. Make a decision about buying or selling and determine the entry and exit points.
Forex correlation trading system
This article discusses a number of currency correlation strategies, but their use in the trading system implies determining the exact entry and exit points for both winning and losing trades. Next Generation is an award-winning trading platform* that allows you to view and trade currency correlations in real time.
On our platform, any currency can be dragged from the product list to an existing chart of any currency pair to show both pairs on the same chart. The following chart compares EUR/USD (candle) and GBP/USD (line). Usually these pairs move together, but in this example they moved in opposite directions. This situation represents a potential deal with an average reversal.
Forex correlation hedging strategy
Correlation allows traders to hedge positions by making a second trade that moves in the opposite direction to the first position. Currency hedging is achieved when the profit on one pair is offset by losses on the other, or vice versa. This can be useful if the trader does not want to exit the position, but wants to compensate or reduce his losses while the pair retreats.
For example, in the table above, EUR/USD and AUD/USD have a strong positive correlation at 75. Buying EUR/USD and selling AUD/USD creates a partial hedge. Partial, because the correlation is only 75, and the correlation does not take into account the magnitude of the price movement, only the direction.
In the case of GBP/USD and EUR/GBP, there is a negative correlation. Therefore, buying or selling both currencies creates a hedge. Buying GBP/USD will bring profit if GBP/USD grows, but this profit will be offset by the fall of the long position on EUR/GBP due to negative correlation.
Why correlations are important
Correlations can have a significant impact on the overall level of risk and the final result, mainly because they contradict the principles of diversification and may mean that the movement of one market against you will affect your entire portfolio.
For example, if you have short positions in two markets with a 75% positive correlation, it is likely that a bearish trend in one of them will lead to the same movement in the other.
In this case, you risk losing the capital allocated to both positions if one of them goes against you. Thus, the overall risk of the transaction may be higher than you originally planned.
If you have several correlated positions, then the overall risk at the portfolio level may be much higher than you think. Therefore, it is always worth studying which markets are interconnected and which of them can contribute to diversification.
The Bottom Line
To be an effective trader and understand your risks, it is important to understand how different currency pairs move in relation to each other. Some currency pairs move in tandem with each other, while others may be polar opposites. Studying the correlation of currencies helps traders to manage their portfolios more competently. Regardless of your trading strategy and whether you want to diversify your positions or find alternative pairs for leverage, it is very important to keep in mind the correlation between different currency pairs and their changing trends.