Trading Forex requires great knowledge of technical indicators and fundamental events. Although most traders tend to focus on either one or the other of the aforementioned approaches, nowadays, more attention is also paid to proper trading psychology and risk management.
This is where currency correlation comes into play, as it is strongly connected with risk management and can help you understand the market when you are trading a little bit better. An understanding about the correlation between the currency pairs helps you to avoid over-trading, and using your margin to hold less desired assets. This article will explain what currency correlation is, how to understand it, and ultimately how to improve your trading strategy by adding currency correlation knowledge to it.
What is currency correlation?
It's easy to see why currencies are interdependent . If you are trading the British pound against the Japanese yen (GBP/JPY), you are actually trading an offshoot of the GBP/USD and USD/ JPY pairs; both currencies GBP/JPY share a relationship with the US dollar and as such a correlation to each other. While some currency pairs will move in the same direction, others may follow the opposite direction. This is the result of more compound forces.
In financial terms, correlation is the numerical measure of the relationship between two variables. The range of correlation coefficient is between -1 and +1. A correlation of +1 denotes that the two currency pairs will flow in the same direction. A correlation of -1 indicates that the two currency pairs will move in contradictory direction 100% of the time, whereas the correlation of zero denotes that the relationship between the currency pair is completely arbitrary.
Change in correlation
It's obvious that changes in correlation do exist, which makes calculating correlation very important. Global economic factors are dynamic - they can and do change on daily basis. Correlations between two currency pairs may vary over time and as a result a short term correlation might contradict the projected long term correlation.
Looking at correlations over the long term provides a clearer picture about the relationship between two currency pairs - and as such this tends to be a more precise and definitive data point .There are many reasons for a change in correlation.The most common are deviating monetary policies, sensitivity of certain currency pairs to commodity prices, as well as political and economic factors.
Calculation of correlation
The ideal way to strengthen your position is to calculate your correlation pairing yourself. It sounds complex, but it's actually quite simple. Use a spreadsheet, like Microsoft Excel, and you can calculate a simple correlation. Using a charting package, download historical daily currency prices and import them into the Excel spreadsheet. You can then use the correlation function in Excel that is =CORREL (range1, range2). The most comprehensive view of changes in correlation over time are returned by using data over periods of one year, six months, three months and one month trailing data .
Although correlation ratios do change, it is not compulsory to bring your numbers up-to-date everyday. It is however, a good idea is to update them once every few weeks or once a month at least.
Each country has a different monetary policy in a different cycle, so changes to these will affect some currencies more than others.
Avoiding Margin Calls
Follow Our Journey
How to use currency correlation in Forex trading
Understanding correlated currency pairs is vital to determining your portfolio's exposure to market volatility. Since currency trades in these pairs and no pair trades in a vacuum, it's critical to risk mitigation that you learn about these correlations and how they change.
Why do these Forex currency correlations exist? It's actually fairly simple. If you're trading currency A against currency B, you would actually be trading a derivative pairing of these currencies versus the US dollar. While the reasoning is easy to understand, the behavior isn't always so straightforward. Certain pairs may move in tandem, while others may move in opposite directions.
The first step to understanding the complex ecosystem of these changes is to look at a currency correlation chart. This chart will illustrate the correlations between currency pairs over a period of time, and from this information you can discern the likely future behaviors of currency pairs. For instance, strong positive correlations – shown as a numerical coefficient – will show an active link between the value of one currency pair and another; as one rises, so does the other at a rate indicated by the coefficient.
Correlation trading tips
Bear in mind that correlations do change, and past performance is not always a guaranteed indicator of future correlation. However this information can be used to develop your own currency correlation strategy to minimize your portfolio's exposure.
Avoid positions that cancel each other out. If you see two currency pairs that move in opposite directions nearly all of the time, then you would realize that holding long positions in both of those currencies mitigates any potential gain that could be had.
Diversify with minimal risk. By investing in two currency pairs that are almost always positively correlated, one can mitigate risks over time while maintaining a positive directional view.
Hedge exposure. Losses can be minimized by hedging two currency pairs that hold a near-perfect negative correlation. The reasoning is simple. If you hold a position with a currency pair that loses value, the opposing currency (having a negative correlation to that pair) will likely gain, albeit with a lower final value. While such a strategy won't completely mitigate losses, those losses will very likely be reduced.
Forex currency correlation strategy
There is no particular trading strategy when it comes to currency pair correlation. By saying this, we mean that there is no particular set of trading instruments that are recommended for trading. However, in the last few years it has become quite common to trade currency correlations in regards to extending your portfolio of trading assets to 20 or more currency pairs with correlation between -0.2 and +0.8. This is also known as correlation trading. In this way a trader tries to benefit from the market moves on multiple assets. Generally, a market move of asset 1 will be compensated with a similar move of asset 2 and so on. The idea behind this approach is to eliminate any losing trades as quickly as possible. This way one can generally receive minor gains over a short period of time.
It is important to keep a close eye on currency correlation tables, because correlation may differ enormously throughout various time-frames. For example, currently (17 April 2015) EUR/USD is correlated with EUR/GBP -1 on the one hour chart, while on a one year chart the correlation is 0.94. This is why currency correlation trading should be done only with a clear understanding of what correlation is and how you can benefit from it.
There are a few things you need to do before you can start correlation trading. First, you need to pick up the right set of assets. The rule of thumb here is quite simple - don't go for the pairs you know nothing about. As with any other trading, you should have a good overview about potential market movements, as it would be hard for you to predict the moves of the currencies you don't know much about. It might be tricky to build a large portfolio straight away, but you can build up the number of pairs as your experience and expertise grows.
After you have picked the pairs, try to observe their correlation within correlation tables or via a special currency correlation indicator inside of your trading platform.
Generally, it can be expensive to trade currency correlations over a long time frame due the cost of overnight swaps that keep the positions open, this is why you should mainly focus on short term correlation. However, long term correlation could be used as an indicator and for confirmation of your trades or trade ideas .
Once you have a better overview about the correlations and their possible impact on the price, start trading correlation on the pairs of your choice. We suggest to start with demo account trading first. The main idea would be to open around 10 positions at once. Try to split your portfolio into first premier categories - pairs that have negative correlation. After that, try to make sure that these pairs do not have a large degree of correlation to each other. Then, when you see price movements, identify the direction of the trade and remove the losing positions from your portfolio.
A good tip to give here is to consider setting your stop-loss on the winning trade, so they are at least equal to the loss that resulted from the closure of the losing trade, plus the cost of the spread and the cost of commission (if any) plus one pip on top of that. This way you could secure just a small gain on your profitable trade.