This is a guest article by Mario Singh of Ask Mario Singh
A correlation is a relationship between two things. In the world of finance, correlation is the statistical measure of how two types securities move in relation to one another.
Based on this definition, currency correlation tells us if two currency pairs move in the same, opposite, or totally random direction based on a time period.
When trading currencies, it’s important to remember that since currencies are traded in pairs, that no single currency pair is ever totally isolated.
Correlation coefficient, which ranges between -1 and +1.
Perfect positive correlation – (a correlation coefficient of +1) implies that the two currency pairs will move in the same direction 100% of the time.
Perfect negative correlation – (a correlation coefficient of -1) means that the two currency pairs will move in the opposite direction 100% of the time.
Correlation=0, the movements between two currency pairs is said to have uh ZERO or NO correlation, they are completely independent and random from each other. We have no idea how one pair will move in relation to the other.
A coefficient near or at -1 indicates that the two pairs still have strong correlation, but a negative one, resulting in the pairs moving in opposite directions.A coefficient near or at zero indicates a very weak or random relationship.
How to use Currency Correlations in Your Trading
1. Eliminate counterproductive trading
Utilizing correlations can help you stay out of positions that will cancel each other out. For example, if we know that EUR/USD and USD/CHF move in the opposite direction 100%, opening a position long EUR/USD AND long USD/CHF is, then, pointless and sometimes expensive. In addition to paying for the spread twice, any movement in the price would take one pair up and the other down.
2. Leverage profits or losses
You have the opportunity to double-up on positions to maximize profits. Again, let’s take at look at the 1 week EUR/USD and GBP/USD relationship.These two pairs have a strong positive correlation with GBP/USD following behind EUR/USD virtually step for step.
Opening a long position for each pair would, in effect, be like taking EUR/USD and doubling your position.
3. Diversify risk
Understanding that correlations exist also allows you to use different currency pairs, but still leverage your point of view. Rather than trading a single currency pair all the time, you can spread your risk across two pairs that move the same way.
Pick pairs that have a strong to very strong correlation (around 0.7). For example, EUR/USD and GBP/USD tend to move together. The imperfect correlation between these two currency pairs gives you the opportunity to diversify which helps reduce your risk. Let’s say you’re bullish on USD.
Instead of opening two short positions of EUR/USD, you could short one EUR/USD and short one GBP/USD which would shield you from some risk and diversify your overall position.
In the event that the U.S. dollar sells off, the euro might be affected to a lesser extent than the pound.
4. Hedge risk
Although hedging can result in realizing smaller profits, it can also help to minimize losses. If you open a long EUR/USD position and it starts to go against you, open a small long position in a pair that moves opposite EUR/USD, such as USD/CHF.
Major losses averted!
You can take advantage of the different pip values for each currency pair in your forex trading strategies.
For example, while EUR/USD and USD/CHF have an almost perfect -1.0 inverse correlation, their pip values are different. Assuming you trade a 10,000 mini lot, one pip for EUR/USD equals $1 and one pip for USD/CHF equals $0.93.
If you buy one mini lot EUR/USD, you can HEDGE your trade by buying one mini lot of USD/CHF. If EUR/USD falls 10 pips, you would be down $10. But your USD/CHF trade would be up $9.30.
Instead of being down $10, now you’re only down $0.70!
Even though hedging sounds like the greatest thing since sliced bread, it does have some disadvantages. If EUR/USD rallies, your profit is limited because of the losses from your USD/CHF position.
Also, the correlation can weaken at anytime. Imagine if EUR/USD falls 10 pips, and USD/CHF only goes up 5 pips, stays flat, or heck, falls also! Your account will be bleeding more red then you will like.
So be careful when hedging!
5. Confirm breakouts and avoid fakeouts
You can use currency correlations to confirm your trade entry or exit signals.
For example, the EUR/USD appears to be testing a significant support level. You observe the price action and are looking to sell on a breakout to the downside.
Since you know EUR/USD is positively correlated with GBP/USD and negatively correlated with USD/CHF and USD/JPY, you check to see if the other three pairs are moving in the same magnitude as EUR/USD.
You notice that GBP/USD is also trading near a significant support level and both the USD/CHF and USD/JPY are trading near key resistance levels.
This tells you that the recent move is U.S. dollar-related and confirms a possible breakout for EUR/USD since the other three pairs are moving similarly. So you decide you will trade the breakout when it occurs.
Now let’s assume the other three pairs are NOT moving in the magnitude as EUR/USD. The GBP/USD is holding not falling, USD/JPY is not rising, and USD/CHF is sideways.
This is usually a strong sign that the EUR/USD decline is not U.S. dollar-related and most likely driven by some kind of negative EU news.
Price may actually trade below the key support level you’ve been monitoring but because the other three correlated pairs aren’t moving in proportion with EUR/USD, there will be lack of any price follow-through and price will return back above the support level resulting in a fakeout.
If you still wanted to trade this setup, since you didn’t get any “correlation confirmation” from the other pairs, you could play it smart by reducing your risk and trading with a smaller position size.
About the Author:
Mario Singh is the owner of the popular forex trading strategy site Askmariosingh.com