UNDERSTAND CURRENCY CORRELATION Understanding price relationships between various currency pairs allows you to get a more in-depth look at how to develop high-probability Forex trading strategies. Awareness of currency correlation can help to reduce risk, improve hedging, and diversify trading instruments. In this article, we will introduce you to Forex trading using intermarket correlations.
Meaning of currency pairs correlation in Forex
Correlation is a statistical measure of the relationship between two trading assets. Currency correlation shows the extent to which two currency pairs have moved in the same, opposite, or completely random directions within a particular period.
Analysis of two asset relationships using past statistical data has predictive value. By utilising the correlation coefficient, we can understand the relationship between two values and help manage risk.
Impact of currency correlations on Forex trading
They can form a basis of a statistically high probability Forex trading strategy.
They can illustrate the amount of risk you are exposed to within your Forex trading account. For example, if you have bought several currency pairs with a strong positive correlation, then you are exposed to higher directional risk.
You can avoid positions that effectively cancel each other out. EUR/USD and USD/CHF have a powerful negative correlation. If you have a directional bias, buying both EUR/USD and USD/CHF will counteract the moves in each pair.
Understanding correlations can allow you to hedge or diversify your exposure to the Forex market.
If you have a directional bias for a given currency, you can spread your risk using two strongly positive correlated pairs, in terms of diversification.
If you are looking to hedge a position (holding it with low risk of losses) you can take a position in a negatively correlated pair. If you were to initiate a ‘long buy’ for EUR/USD, and it begins to move in an unfavourable direction, you can then hedge your position by purchasing a currency pair that has a negative correlation to EUR/USD, like USD/CHF.
Currency correlations change in Forex
Be aware that currency correlations are continually changing over time due to various economic and political factors. These often include diverging monetary policies, commodity prices, changes in central banks’ policies, and more. Given that strong correlations can change over time, it highlights the importance of staying up to date in shifting currency relationships. We recommend checking long-term correlations to acquire a more in-depth perspective.
All in all, currency correlations could be a powerful tool you can use to develop high-probability trading strategies. You'll also be aided in risk management, mainly if you track the correlation coefficients over daily, weekly, monthly and yearly timeframes.
