Currency pairs correlation explained
If you are a Forex trader, then one of the things that you want to understand is currency pairs correlation. Correlation is the historic co-movement between two exchange rates, usually calculated using linear regression over a specific period. While there are many different correlations, ranging from complete positive correlation to complete negative correlation, most traders look for uncorrelated markets when making trading decisions.
How do currency pairs correlate with each other?
It may seem counterintuitive that price movements in one market would be correlated with price movements in another market. If you are trading the AUD/USD, why should you care what’s happening to EUR/GBP?
The thing that most people forget is that currencies tend to move in pairs. This means that if one currency strengthens, then another one will weaken. For example, suppose the US Federal Reserve announces an interest rate hike. In that case, it will strengthen the US dollar and likely weaken other major world currencies like the Euro or Japanese Yen.
Why is correlation significant?
Correlation can help you avoid significant losses: If one of your Forex pairs goes against you (e.g., bullish EUR/USD), the other will probably follow suit (bearish USD/CAD). This means that you should reduce your position size on the second “diversification” currency pair. You may also want to consider trading an alternative strategy like range trading or trend trading.
How correlation can help you make better trading decisions
Traders often get focused on one market at a time (e.g., following EUR/USD only). While they may not be making bad trades, they aren’t taking advantage of opportunities in other markets either. If you always correlate with your favourite trade (e.g., AUD/USD only), you will never know what’s happening to “unrelated” Forex pairs like NZD/JPY or GBP/CHF. T
When do currency pairs have a high positive correlation?
A high positive correlation occurs when two currencies both move in the same direction. For example, if the US dollar strengthens against other world currencies (e.g., AUD, CAD, NZD), the favourite USD/CAD and USD/AUD pairs will move up in value together.
A high positive correlation occurs when the major fundamental factor affects both markets (interest rate hike announcements, central bank monetary policy decisions). This means that while positive correlation can be very rewarding (since two groups of Forex traders are moving in the same direction), it’s also risky since a significant event could come along and destroy your gains.
When do currency pairs have a high negative correlation?
A high negative correlation occurs when one market moves up while another market simultaneously moves down. For example, if EUR/ USD and USD/JPY start moving lower, the EUR/JPY and USD/CAD pairs will move up together.
High negative correlation occurs when one market reacts to a significant fundamental event (e.g., Federal Reserve interest rate hike) while another market is not. Again, this sort of correlation can be profitable because you now have two groups of Forex traders moving in opposite directions. Still, it can also show signs that market sentiment is shifting away from certain currencies or countries.
When do currency pairs have a low positive or negative correlation?
Low positive or negative correlations occur when there’s no clear relationship between markets at all. For example, if GBP/USD starts to send out bearish signals whereas AUD/USD is sending out bullish ones, the GBP/AUD pair might start to move down while AUD/USD rises.
Low correlations are widespread in Forex markets since every trade has its own risk profile, so it’s unlikely two markets will ever have precisely the same risk and return profile. However, you shouldn’t focus on correlated pairs alone; if you do, then you’ll miss out on opportunities to diversify your portfolio with “unreliable” currencies like EUR/GBP or USD/CHF.
If traders understand the relationship between currency pairs, then they can plan their Forex trading strategy accordingly. New traders can use the online demo account offered by saxotrader before making a real-time investment.