CURRENCY CORRELATIONS
Correlation only shows exactly how two assets move in relation to each other. In the case of currency correlation, it is exactly the same story. Forex pairs can move together, in different directions, or not interact at all. Keep in mind that we are not trading just currencies, we are trading a currency pair where each participant in the pair influences the other. Therefore, correlation can be a useful tool, and almost the only one if you want to successfully trade several currency pairs at once.
Currency correlation is based on the so-called correlation coefficient, which is in a simple range between -1 and +1.
• Perfect positive correlation (coefficient of +1) means that two currency pairs move in the same direction 100% of the time.
• A perfect negative correlation (coefficient -1) implies exactly the opposite. Pairs constantly move in different directions.
If the correlation is 0, then there is no correlation at all, it is zero and the pairs are not related in any way.
The Risks of Currency Correlations
If you trade several currency pairs at once, you must realize at once how much such trading is exposed to risk. Sometimes people choose several pairs at once in order to minimize their risks, but they forget about the positive correlation, when pairs go in the same direction.
Let's assume that we took two pairs on the 4-hour timeframe, EUR/USD and GBP/USD. The correlation coefficient is 0.94, very nice. This means that both pairs are literally following each other.
If we open trades on both pairs, we thereby immediately double our position and the risks. They increase. Because if you are wrong with the forecast, you will be doubly wrong at once, because the pairs are mirrored.
You have put it up, the price went down, a double loss. So there is correlation. Also, it makes no sense to sell one instrument and buy another, because even with an accurate forecast one of them will bring you a loss.
The volatility also differs. One pair might jump 200 pips, while the other might jump only 180 pips. That's why it's necessary to play with simultaneous trades on different pairs very carefully and without fanaticism, the correlation decides everything here.
Now let's compare the opposite case, EUR/USD and USD/CHF. They have the opposite case, a strong inverse correlation, where the coefficient often reaches the absolute value of -1.00.
The pairs are like two magnets with opposite poles, constantly pushing away from each other. If you open opposite trades on two pairs with a negative correlation, it will be the same as two identical trades on pairs with a positive correlation, again doubling your risk. The most reasonable thing is definitely to work with only one pair and not to play with the opposite pair trades, because you can quickly reach ugly values.
Correlation coefficients
Now let's see how we can look at the correlation coefficients.
-1.0. Perfect inverse correlation.
-0.8. Very strong inverse correlation.
-0.6. Strong inverse correlation.
-0.4. Moderate inverse correlation.
-0.2. Weak inverse correlation
0. No correlation
0.2 Weak, slight correlation
0.4. Weak correlation
0.6. Moderate correlation
0.8. Strong correlation
1.0. Perfect correlation
So what to do with the correlation, can it be used or not?
1. Eliminate risk
If you like to open simultaneous trades on different pairs, knowing about their correlation will help you avoid getting into the described situation where you double your risk if two pairs go in the same direction. Or you bet in different directions, not realizing that the pairs have an inverse correlation and this again doubles your risk.
2. Doubling your profits or losses
If you decide to play with simultaneous trades on different pairs, a successful trade on pairs that have a direct correlation will double your profits. Or losses, of course, if something went wrong and the forecast was wrong.
3. Risk Diversification
Market risks can be divided into two currency pairs. If you certainly understand what you are doing and if the correlation between pairs is not perfect. To do so, we take pairs with a direct correlation around 0.7 (or higher), say EUR/USD and GBP/USD. Let's say you bet on USD going up. Instead of two bets on EUR/USD going down, you could bet on EUR/USD going down and GBP/USD going up. If the dollar falls, the euro will be less affected than the pound.
4. Risk Hedging
This method is already used in forex, where it is taken into account that each currency pair has its own pip value. If you have an upside position in EUR/USD and the price moves against you, a downside position in an opposite pair, such as USD/CHF, can help. You should not forget about the different pip value in forex. For example, the EUR/USD and USD/CHF have a nearly perfect correlation, except that when trading a $1000 mini lot, one pip of the EUR/USD costs $1, while USD/CHF costs $0.93. As a result, buying a EUR/USD minilot allows you to hedge your risks while simultaneously buying a USD/CHF minilot. If the EUR/USD falls 10 pips, you lose $10. However, the return on the USD/CHF will be $9.30. So instead of $10, you would only lose 70 cents, fine.
Hedging in forex looks great, but there are plenty of drawbacks as well. For when EUR/USD rises frantically, you simultaneously lose money on USD/CHF. Also, the correlation is rarely perfect, it's constantly floating, so instead of hedging you could lose everything.
5. Correlation, Breakouts and False Breaks
Correlation can also be used to predict price behavior at significant levels. Let's assume that the EUR/USD is testing a significant support level. We have studied it and decided to enter upon its breakout. Since EUR/USD is positively correlated with GBP/USD and negatively correlated with USD/CHF and USD/JPY, we should check if the other three pairs are moving in the same volatility as EUR/USD.
Most likely, GBP/USD is also near resistance levels, and USD/CHF and USD/JPY are near key resistance levels too. All this means that the USD move the market and there are all the indications for a breakout of the EUR/USD, because all the three pairs are moving synchronously. We have to wait for the breakout.
And now let's assume that these three pairs do not move synchronously with EUR/USD. GBP/USD has no intention to fall, USD/JPY does not increase, and USD/CHF does not show any signs of sideways movement. What does this mean? The only thing that the fall of EUR/USD is not connected with the dollar and is obviously caused by negative news from the Eurozone.
The price can be below the key support level, but if the three correlated pairs do not move synchronously enough with EUR/USD, we should not expect a breakout. Moreover, it can be a false break of resistance.
Yes, you can still enter the breakout without a correlation confirmation, but then make a smaller trade volume, because you need to reduce your risks.
Correlation: pros and cons
Here everything is obvious. The cons are your risks are doubled if you open trades for two mirrored correlated pairs. In addition, the correlation changes regularly at different time intervals, which should be taken into account in your work. The pros are correlation allows you to diversify risks, hedge your trades.
Also remember that:
ratios are calculated based on daily closing prices;
a positive coefficient means that two pairs move in the same direction;
negative in opposite directions;
the closer the coefficient is to values +1 and -1, the stronger the correlation.
Examples of pairs that move synchronously:
EUR/USD and GBP/USD;
EUR/USD and AUD/USD;
EUR/USD and NZD/USD;
USD/CHF and USD/JPY;
AUD/USD and NZD/USD.
Pairs with negative correlation:
EUR/USD and USD/CHF;
GBP/USD and USD/JPY;
USD/CAD and AUD/USD;
USD/JPY and AUD/USD;
GBP/USD and USD/CHF.
Do not forget to use all that you have learned, keep in mind the risk management, and then the currency pairs correlation may become a valuable tool in your trading arsenal. And most importantly, it will allow you to avoid mistakes when you trade two pairs at once and don't even realize that you are doubling your risks if there is a complete synchronous correlation between the selected pairs.
Currency correlation is based on the so-called correlation coefficient, which is in a simple range between -1 and +1.
• Perfect positive correlation (coefficient of +1) means that two currency pairs move in the same direction 100% of the time.
• A perfect negative correlation (coefficient -1) implies exactly the opposite. Pairs constantly move in different directions.
If the correlation is 0, then there is no correlation at all, it is zero and the pairs are not related in any way.
The Risks of Currency Correlations
If you trade several currency pairs at once, you must realize at once how much such trading is exposed to risk. Sometimes people choose several pairs at once in order to minimize their risks, but they forget about the positive correlation, when pairs go in the same direction.
Let's assume that we took two pairs on the 4-hour timeframe, EUR/USD and GBP/USD. The correlation coefficient is 0.94, very nice. This means that both pairs are literally following each other.
If we open trades on both pairs, we thereby immediately double our position and the risks. They increase. Because if you are wrong with the forecast, you will be doubly wrong at once, because the pairs are mirrored.
You have put it up, the price went down, a double loss. So there is correlation. Also, it makes no sense to sell one instrument and buy another, because even with an accurate forecast one of them will bring you a loss.
The volatility also differs. One pair might jump 200 pips, while the other might jump only 180 pips. That's why it's necessary to play with simultaneous trades on different pairs very carefully and without fanaticism, the correlation decides everything here.
Now let's compare the opposite case, EUR/USD and USD/CHF. They have the opposite case, a strong inverse correlation, where the coefficient often reaches the absolute value of -1.00.
The pairs are like two magnets with opposite poles, constantly pushing away from each other. If you open opposite trades on two pairs with a negative correlation, it will be the same as two identical trades on pairs with a positive correlation, again doubling your risk. The most reasonable thing is definitely to work with only one pair and not to play with the opposite pair trades, because you can quickly reach ugly values.
Correlation coefficients
Now let's see how we can look at the correlation coefficients.
-1.0. Perfect inverse correlation.
-0.8. Very strong inverse correlation.
-0.6. Strong inverse correlation.
-0.4. Moderate inverse correlation.
-0.2. Weak inverse correlation
0. No correlation
0.2 Weak, slight correlation
0.4. Weak correlation
0.6. Moderate correlation
0.8. Strong correlation
1.0. Perfect correlation
So what to do with the correlation, can it be used or not?
1. Eliminate risk
If you like to open simultaneous trades on different pairs, knowing about their correlation will help you avoid getting into the described situation where you double your risk if two pairs go in the same direction. Or you bet in different directions, not realizing that the pairs have an inverse correlation and this again doubles your risk.
2. Doubling your profits or losses
If you decide to play with simultaneous trades on different pairs, a successful trade on pairs that have a direct correlation will double your profits. Or losses, of course, if something went wrong and the forecast was wrong.
3. Risk Diversification
Market risks can be divided into two currency pairs. If you certainly understand what you are doing and if the correlation between pairs is not perfect. To do so, we take pairs with a direct correlation around 0.7 (or higher), say EUR/USD and GBP/USD. Let's say you bet on USD going up. Instead of two bets on EUR/USD going down, you could bet on EUR/USD going down and GBP/USD going up. If the dollar falls, the euro will be less affected than the pound.
4. Risk Hedging
This method is already used in forex, where it is taken into account that each currency pair has its own pip value. If you have an upside position in EUR/USD and the price moves against you, a downside position in an opposite pair, such as USD/CHF, can help. You should not forget about the different pip value in forex. For example, the EUR/USD and USD/CHF have a nearly perfect correlation, except that when trading a $1000 mini lot, one pip of the EUR/USD costs $1, while USD/CHF costs $0.93. As a result, buying a EUR/USD minilot allows you to hedge your risks while simultaneously buying a USD/CHF minilot. If the EUR/USD falls 10 pips, you lose $10. However, the return on the USD/CHF will be $9.30. So instead of $10, you would only lose 70 cents, fine.
Hedging in forex looks great, but there are plenty of drawbacks as well. For when EUR/USD rises frantically, you simultaneously lose money on USD/CHF. Also, the correlation is rarely perfect, it's constantly floating, so instead of hedging you could lose everything.
5. Correlation, Breakouts and False Breaks
Correlation can also be used to predict price behavior at significant levels. Let's assume that the EUR/USD is testing a significant support level. We have studied it and decided to enter upon its breakout. Since EUR/USD is positively correlated with GBP/USD and negatively correlated with USD/CHF and USD/JPY, we should check if the other three pairs are moving in the same volatility as EUR/USD.
Most likely, GBP/USD is also near resistance levels, and USD/CHF and USD/JPY are near key resistance levels too. All this means that the USD move the market and there are all the indications for a breakout of the EUR/USD, because all the three pairs are moving synchronously. We have to wait for the breakout.
And now let's assume that these three pairs do not move synchronously with EUR/USD. GBP/USD has no intention to fall, USD/JPY does not increase, and USD/CHF does not show any signs of sideways movement. What does this mean? The only thing that the fall of EUR/USD is not connected with the dollar and is obviously caused by negative news from the Eurozone.
The price can be below the key support level, but if the three correlated pairs do not move synchronously enough with EUR/USD, we should not expect a breakout. Moreover, it can be a false break of resistance.
Yes, you can still enter the breakout without a correlation confirmation, but then make a smaller trade volume, because you need to reduce your risks.
Correlation: pros and cons
Here everything is obvious. The cons are your risks are doubled if you open trades for two mirrored correlated pairs. In addition, the correlation changes regularly at different time intervals, which should be taken into account in your work. The pros are correlation allows you to diversify risks, hedge your trades.
Also remember that:
ratios are calculated based on daily closing prices;
a positive coefficient means that two pairs move in the same direction;
negative in opposite directions;
the closer the coefficient is to values +1 and -1, the stronger the correlation.
Examples of pairs that move synchronously:
EUR/USD and GBP/USD;
EUR/USD and AUD/USD;
EUR/USD and NZD/USD;
USD/CHF and USD/JPY;
AUD/USD and NZD/USD.
Pairs with negative correlation:
EUR/USD and USD/CHF;
GBP/USD and USD/JPY;
USD/CAD and AUD/USD;
USD/JPY and AUD/USD;
GBP/USD and USD/CHF.
Do not forget to use all that you have learned, keep in mind the risk management, and then the currency pairs correlation may become a valuable tool in your trading arsenal. And most importantly, it will allow you to avoid mistakes when you trade two pairs at once and don't even realize that you are doubling your risks if there is a complete synchronous correlation between the selected pairs.
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