Currency correlation, also known as forex correlation, is a statistical measure of how closely currency pairs are linked in value and move together. Currency correlation is important for traders to understand and monitor because they can influence their degree of risk when trying to trade in the forex market. The correlation coefficient formula represents the strength or weakness of their relationship. Traders may choose to hedge their positions by buying negatively correlated forex pairs in the hopes that gains in one will be offset by losses in the other.
Currency correlation occurs when the prices of two different or even more currency pairs move in perfect sync. As a forex trader, you must understand the correlation between currency pairs because currency correlation can impact your trading account's exposure and risk. A foreign exchange-correlation is the relationship that exists between two currency pairs. When two pairs move in the same direction, there is a positive correlation; when they move in opposite directions, there is a negative correlation, also known as the inverse correlation; and there is no correlation if the pairs move randomly with no detectable relationship.
Currency correlation is essential for brokers to fully comprehend because it can have an immediate impact on forex trading outcomes, often without the trader's knowledge. For instance, assuming a trader purchases two separate currency pairs that are negatively correlated, gains in one can be offset by losses in the other, resulting in a common hedging strategy. On the other hand, buying two correlated pairs may double the risk and profit potential, as both exchanges will result in a loss or profit because the pairs move in the same direction and are not completely independent of each other.
Why are currency correlations important?
Correlations can have a major impact on your general risk level and bottom line, primarily because they work against diversification and can result in one market shift against you affecting your entire portfolio. For example, if you have open short positions in two markets with a 75% positive correlation, a bear trend in one is likely to result in the same move in the other. If one of the positions moves against you, you run the risk of losing the capital made available to both. As a result, your overall risk from the trading activities may be higher than you anticipated. If you have several correlated positions, your total portfolio risk may be much higher than you realize. So it is always worth investigating which markets are closely linked and which can help you diversify.
What is the correlation coefficient?
A correlation coefficient indicates the strength or weakness of a correlation between two forex pairs. Correlation coefficients are attributes and can range from -100 to 100 or -1 to 1, with the decimal indicating the coefficient. which simply means that anything below -100 indicates that the pairs move similarly but in opposite directions, whereas anything above 100 indicates that the pairs move slightly differently in the same direction. The phrase "slightly differently" is significant because correlation only considers direction but not magnitude. For example, one pair may rise to 100 pips (percentages in points), while another falls to 70 pips. Even though the magnitude of the movement differs, both pairs could have a very strong inverse correlation.
If reading is between -70 and 70, it is regarded as having a high correlation, as movements in one are largely mirrored in movements in the other. Readings ranging from -70 to 70, on the other hand, indicate that the pairs are less connected. With forex correlation coefficients close to zero, both pairs have little or no discernible relationship with one another.
Forex correlation hedging strategy
Currency hedging occurs when gains in one pair are offset by losses in the other, or vice versa. This can be useful if a trader does not want to exit a position but would like to offset or decrease their loss while the pair is pulling back.
Correlations can be utilized as an aspect of a forex trading strategy in a variety of ways, including hedging, pairs trading, and commodity correlations. To get started with correlation trading, the below steps will give you a proper guide.
- Select your product: Forex is frequently traded using derivative instruments such as spread betting or CFDs, so it is essential to learn about the differences.
- Investigate the forex market: It is essential to improve your understanding of currency pairs and the factors that influence them, such as inflation, interest rates, and other economic data, before trading correlations.
- Decide on a strategy because it is often a good idea to create a trading plan ahead of time.
- Investigate risk-management tools: stop-loss and take-profit orders, for example, can be useful for risk management in volatile markets, but they do not always safeguard you from market gapping or deterioration.
- Make your trade and keep an eye on it by determining whether one should buy or sell, as well as entry and exit points while keeping profit or loss in mind.
Trading recommendation for currency correlation
- Take into account if the exchanges are presently correlated if one market leads another, and also whether the price is diverging when placing a trade. For instance, if one stock is making lower lows or higher highs while the other is ranging, it may be worthwhile to wait for a sustained period of correlation.
- While trading inversely correlated markets may result in situations where your trades easily cancel each other out, these trades can also be used for hedging. For example, trading EUR/USD with USD/CHF may not be advisable in the long run, but there may be situations where doing so can safeguard against brief negative moves.
- Currency pairs such as the AUD/USD have historically been strongly correlated with gold. For instance, because Australia is a leading player in the industry, the AUD/USD cost may fluctuate depending on the country’s ability to trade the metal. As a result, any correlation trader must be well-informed about the fundamental factors influencing gold production plans and demand patterns.
Effect of currency correlation on Forex trading
- They can serve as the foundation for a forex trading strategy with a statistically high probability.
- They can show you how much risk you are taking with your Forex trading account. For example, if you purchased numerous currency pairs with a significant positive correlation, you are subject to greater directional risk.
- It is possible to avoid positions that successfully eliminate each other. The EUR/USD and the USD/CHF have a strong inverse relationship. If you have a directional bias, buying both the EUR/USD and the USD/CHF will offset the movements in each pair.
- Interpretation of correlations can help you hedge or diversify your Forex exposure.
- In terms of diversification, if you have a directional bias for a given currency, you can disperse your risk by using two highly positively correlated pairs.
- If you want to hedge a position or hold it with a low risk of loss, you can invest in a negatively correlated pair. For instance, if you start a ‘long buy’ for EUR/USD and it starts to move in an unfavourable direction, you can hedge your position by buying a currency pair with a negative correlation to EUR/USD, such as USD/CHF.
It is important to keep in mind that currency correlation changes over time due to a variety of political and economic factors. Some other factors, which include varying monetary policies, asset prices, shifts in central bank policies, and other factors, also play a major role, given the fact that strong correlations can shift over time, it emphasizes the importance of staying current on shifting currency relationships.
