Trading in the forex market involves risk, so it is crucial for traders to fully understand and keep an eye on currency correlations. It can help to increase the chances of profitable trades happening and lower potential risks that may occur. In this article, we’re going to look at how forex correlation is established, how it impacts trades and trading strategies, and other factors that correlate to currency pairs.
What are Forex Correlations?
The relationship between two currency pairs is known as a forex correlations. When two currency pairs move in opposite directions, there is a negative correlation, and if the pairs move randomly with no noticeable link, there is no correlation. Inverse correlation is another name for a negative correlation. Understanding currency correlation is crucial for traders since it can directly affect their forex trading outcomes, continuously without their knowledge.
Consider as well for illustration, a trader who purchases two separate currency pairings that are negatively connected. Gains in one could be counterbalanced by losses in the other, which is a common hedging tactic. Buying two correlated pairs, on the other hand, may increase both risk and profit potential because both transactions will either end in a loss or a gain. Since the pairs go in the same direction, they are not entirely self-sufficient.
Correlation Coefficient Explained
The degree of correlation between two forex pairs is indicated by a correlation coefficient. The decimal value of a correlation coefficient, which might have a range of -100 to 100 or -1 to 1, is shown in values.
Anything around -100 indicates that the pairs travel almost identically but in opposite directions, whereas anything above 100 indicates that the pairs move almost identically but in the same direction. The phrase “almost identically” is key because correlation only considers magnitude in one direction. For instance, one pair might increase by 100 pip (percentages in point), whereas another pair may decrease by 70 pip. Even when the movements in the two pairings were of different sizes, they might still have a very strong negative association.
A value is deemed to have a significant correlation if it is below -70 and above 70 since the movements of one are primarily mirrored in the movements of the other. On the other side, readings between -70 and 70 indicate that there is less correlation between the pairs. Both pairings are displaying little to no relationship with one another, with forex correlation coefficients close to zero.
How To Use Correlations in Forex
The data from currency correlations in forex can be used in a number of different ways. As a sort of diversity, some traders might choose to trade positively linked markets but distribute their risk across many currency pairs.
For instance, traders may search for other markets that have good correlations to the US dollar and spread the risk across them rather than buying just USD/JPY if they are bullish on the US dollar. Diversification into different markets can aid in maintaining the initial traders’ bias if one market takes a negative turn.
Making sure that each position on your trading account has a negligible or nonexistent correlation is another technique to use for forex correlations. In this way, connected currency pair movements in the same direction are not overexposed.
Forex correlations can also be used for currency hedging. A trader may adopt the opposite position on a negatively correlated currency pair if they are holding one particular currency pair. The chosen currency pairs have a negative correlation, so in theory, when one trade moves into a loss, the other transaction may move into a profit.
It’s important to note that correlations are going to fluctuate and alter over time. The market’s current forex pair correlations should therefore always be monitored, and risk management should always come first.
The Top Forex Correlation Pairs
The correlation between many of the most popular currency pairs globally is displayed in the image below. To show how each currency on the y-axis together with those on the x-axis relate to one another, you can compare them. For example, the EUR/USD and GBP/USD have a 77 percent correlation, which is pretty high.
Even though the pairs don’t always move in the same direction, they do so mostly in harmony. On the other hand, the GBP/USD and EUR/GBP have a high negative correlation of -90, indicating that they frequently move in the opposite way.
Even in this small table of currencies, there are a number of significant connections, making it crucial to keep track of currency correlations. Unknowingly, a trader can sell the EUR/GBP and buy the GBP/USD under the impression that they are in two separate positions. The pairs are known to migrate in different directions, even though they have a strong negative connection. As a result of this, since they are not entirely independent trades, the trader is likely to wind up winning or losing on both.
Hedging With Forex Correlation
By entering a second transaction that swings in the opposite direction from the first, traders can use correlation to hedge holdings. Gains from one pair must be countered by losses from another, or vice versa, to accomplish a currency hedge. This may be helpful if a trader wants to offset or decrease their loss when the pair pulls back but does not want to quit a position.
For instance, there is a strong positive correlation of 75 between the EUR/USD and AUD/USD. A partial hedge is made by buying EUR/USD and selling AUD/USD. It is somewhat precise because the connection only accounts for direction and only has a 75 percent correlation coefficient.
There is a negative correlation between the GBP/USD and EUR/GBP. Consequently, hedging involves both purchasing and selling. Purchasing GBP/USD will profit if the pair rises, but the benefits will be reduced by a decline in the long position on EUR/GBP due to the negative correlation.
Pair Trading
Trading pairs involves placing both long and short bets on two currency pairs that have a significant historical correlation, such as 80 or above. A trader can buy the down-trending currency and sell the uptrending currency pair. Given their long record of strong association, the theory behind this is that they will ultimately begin to move in unison once more. This could result in a profit being made.
The risk is that the pairs might not return to having a strong correlation. As a result, to limit their losses, some traders may put a stop-loss order on each position. Even if the pairings return to their former correlation, there is a risk that the loss on one transaction won’t be made up for by a gain on the other, resulting in a loss. As the pairings mean-revert, it would be ideal for the buying pair to move up and the selling position to move down, which might lead to a profit on both trades.
Position sizing is a crucial aspect of risk management when utilizing any strategy, including currency correlation strategies. Many traders choose to risk a tiny portion of their account, depending on where the stop loss is put. For instance, taking a micro lot position means there is a $3 risk on the transaction if the stop loss is 30 pips in the EUR/USD. The trader is required to have a minimum of $300 in the account for that $3 of risk to equal merely 1% of the account. In this manner, both trade and account risk are under control.
Commodities and Currency Pair Correlations
Some currencies’ values are associated with the prices of commodities as well as with the values of other currencies. This is especially true if a nation exports a lot of a certain good, like gold or crude oil.
Crude oil and the CAD
The value of the Canadian dollar and the cost of oil frequently have a positive correlation. The value of the Canadian dollar on the currency market typically rises in response to an increase in the price of oil. Since oil is traded in US dollars, which are typically inversely correlated with the price of oil, this is frequently reflected in movements of the USD/CAD pair.
This implies that the price of oil is more likely to drop when the value of the US dollar rises. It also implies that a rise in oil prices typically results in a fall in the exchange rate of the US dollar. Therefore, when oil prices are rising, traders might use this knowledge to take a long position on the Canadian dollar, such as in the CAD/JPY pair, or a short position on the US dollar, such as in the USD/CAD pair.
AUD’s Correlation to Gold
Especially in the AUD/USD currency combination, the price of the Australian dollar and the price of gold frequently move in conjunction. Australia is a net exporter of gold, therefore when gold prices rise, the AUD/USD exchange rate rises as well. Conversely, when gold prices fall, the AUD/USD exchange rate also falls.
The Australian currency is gaining in relation to the US dollar if the price of AUD/USD increases because you would have to exchange more US dollars to buy one Australian dollar.
Non-correlated Pairs in Forex
When currency pairs move independently of one another, they are said to be non-correlated. This can occur when the currencies in each pair are different or when the economies of the currencies are different.
For instance, the US dollar is present in both EUR/USD and GBP/USD, and the economies of the Eurozone and Great Britain are interconnected. As a result, they frequently move in the same direction; although, this is not always the case. The AUD/USD and EUR/JPY have no corresponding currencies. In reality, the economies of the US, Japan, Australia, and the Eurozone are all distinct from one another. As a result, there is typically less correlation between these pairs.
Conclusion | Forex Correlations
You must understand how multiple currency pairs move in correlation to one another to make trades successfully and be aware of your risks. While certain currency pairs move in unison, others could be completely opposite.
Trading professionals can better manage their portfolios by learning about currency correlation. It is crucial to keep in mind the connection between different currency pairs and their fluctuating trends regardless of your trading approach, your desire to diversify your holdings, or the search for alternative currency pairs to support the perspective you hold.
