UNDERSTANDING CURRENCY CORRELATION

Published : 8 years ago, on 12/10/2016

By Nenad Kerkez, trading expert at Admiral Markets

As most Forex traders know, psychology and risk management are huge factors in their overall success in the financial markets. One specific facet of these factors is currency correlation – a concept which is often overlooked or misunderstood by novice and intermediate traders.

The objective of this article is to explain what currency correlation is, why it’s important to your risk management strategy, and how to apply it in a live trading environment. What is currency correlation?

All currencies are traded in pairs – and as such they share relationships with their counterparts. In other words, currency pairs are correlated with each other.

Becoming sensitive to these correlations will allow you to reduce unnecessary risk when trading. Let’s take a look at the real world example to demonstrate this idea. Consider this scenario: you’re trading the euro (EUR) against the US dollar (USD). If you look closer, you’ll recognise that this pair will be linked to both the EUR/GBP and USD/GBP currency pairs.

The effect of this is that some currency pairs have a positive correlation (their price moves in the same direction), while others have a negative correlation (their price moves in the opposite direction). These are represented numerically on a sliding scale between +1 and -1 respectively. However, there are currency pairs which have a completely random correlation too. This is represented numerically on the sliding scale by 0.

Using correlation tools in a live trading environment

So how do we view the current correlation between currency pairs? Most trading platforms include a currency correlation tool that displays the aforementioned numerical numbers in a table format. Using this tool, you’ll be able to easily locate and identify the correlation of any given two currency pairs across different time frames (please see the example chart below). Doing this can vastly improve your risk management strategy – as it will mean you are more likely to avoid trades that cancel each other out.

Again, let’s look at a real world example of how monitoring currency correlation can help you reduce unnecessary risk in your trades.

Consider our example from earlier, where you were trading EUR/USD. In this example, we’re going to assume that you take a ‘long’ position on this pair – where you back the price of this pair rising. In addition to this trade, you want to simultaneously take a long position on EUR/GBP – again backing the price of that pair to rise.

However, before you place the second trade, you can check the correlation between EUR/USD and USD/CHF. At the time of writing, the correlation between these two pairs is -96, which tells us that 96% of the time in the past 500 hours these two pairs’ prices moved in opposite directions. This is an indicator that taking long positions on both of these pairs at the same time is likely to result in the trades cancelling each other out in your profit and loss account. That is called “negative correlation”.

Hopefully you can see the potential that monitoring currency correlation brings here. If you are feeling confident about a particular currency and the position you want to take – either long or short – you should look to capitalise by also taking the same position on a pair that has a strong positive correlation with your original pair. As demonstrated above, it’s also a brilliant tool for improving your risk management strategy – which means you’ll become a better and more profitable Forex trader.