How to Identify Currency Pair Correlation and Profit from Them
The foreign exchange (Forex) market is the largest and most liquid financial market in the world, with over 7 trillion dollars traded daily. Most traders focus on currency pairs, converting currency A into currency B, for example: EUR/USD (Euro vs U.S. dollar) or USD/JPY (U.S. dollar vs Japanese yen) etc. Currency pairs represent the value of one currency against another.
Most traders will analyze their pair independently which is okay, but successful currency trading depends upon an understanding of pairs' correlations with one another.
So what is correlation? Quite simply, correlation is a measurement of how two things move together. For example, if the weather is hot in the summer then ice cream sales increase, and furthermore if the weather is hot in the summer, then sales of cold drinks tend to increase as well, in that case you would say that ice cream and cold drink sales are positively correlated (the variables go up together).
On the other hand, if one variable tends to go higher while the other variable tends to go lower, then you would say that they are negatively correlated. When we talk about currency pairs there is the same correlation attributed to them, some pairs may move in the same direction (positive correlation) while other pairs may move in the opposite direction.
Why is Correlation important? It is important because correlation directly translates into either profits or losses. Using the example of two pairs that have a very strong correlation, EUR/USD and GBP/USD, if you open buy trades on EUR/USD and GBP/USD at the same time you are doubling the amount of risk exposure in those trades.
Alternatively, knowing negative correlation like USD/JPY and Gold, you can construct hedging strategies to manage risk exposure in times of extreme market movements.
With full understanding of correlation, traders can:
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Control risk from their positions by avoiding position redundancy.
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Identify arbitrage opportunities through correlated pairs divergence.
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Hedge positions by combining pairs that typically have opposite movements.
In this blog, we will start with the fundamental principles of correlation, look at a few common relationships of currency pairs, examine how to measure or identify a correlation, and finish with some more advanced trading ideas or risks management strategies to incorporate into your trading.
We will also look at correlations and relationships with currency pairs in real time, including how psychology, events and economic situations created those correlations.
By the end of the blog, you will not just understand what currency pair correlation is, but more importantly learn how to put it into action when making trading decisions.
II. Currency Pair Correlation Basics
To trade Forex successfully, it is simply not enough to consider the movement of one currency pair on its own. The Forex market is tightly linked within itself and it is often impossible to see how one currency pair impacts others. This is why correlation is helpfula statistical measurement of how two variables move in relation to each other.
What Is Correlation?
In finance, correlation helps determine if two assets (or currency pairs) tend to move together or in the opposite direction. The strength of this relationship is referred to as the correlation coefficient and is expressed as a number ranging from 1 to +1:
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+1 (Perfect Positive Correlation): The two pairs move in the same direction at the same time
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0 (No Correlation): The movements of the pairs have no relation to each other
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1 (Perfect Negative Correlation): When one pair goes in the opposite direction by the same percentage.
An example would be:
EUR/USD and GBP/USD exhibit a very strong positive correlation (around +0.9).
USD/JPY and Gold have a negative correlation: when the yen appreciates against the dollar, gold is often on the rise.
What Is Behind Correlations?
Correlations do not happen by chance. There are economic and structural connections in the global economy that lead to or explain correlations with currency pairs:
Common currencies – If two pairs share a base or a quote currency, then their movements will be related, at least to some degree.
For example: EUR/USD and GBP/USD both are quoted against the U.S. dollar, so when the dollar is stronger (or weaker), it will exert an influence on both pairs.
Economic connections – Forex pairs with countries that are of geographic or economic distance make for correlated currencies more often than not.
For example: AUD/USD and NZD/USD both are impacted with commonalities for trade and economy in Australia and New Zealand.
Market sentiment – Often times, traders may become riskon and along with the optimistic price action, may buy several "risk currencies" at the same time. This leads to a higher number of positive correlations with the market sentiment in mind.
Historical correlations vs rolling correlations
Correlations are not stable and there may be a pair that is correlated for years but based on a change in monetary policy, economic events, or market sentiment the currencies can diverge. This is why traders will often compare the difference between historical correlation (i.e. average over long periods of time) and the rolling correlation (calculated over moving time frames such as 30 days 0r 90 days).
Historical correlation gives you a broad picture of how pairs may have behaved in the past. Rolling correlation shows the relationship that created that history and lets you see how it evolves over time.
Measuring Correlation: The Key to Risk Management
For traders, personally measuring correlation is important. By measuring the correlation between two pairs, traders are able to figure out whether they are 0.9 positive, or 0.7 negative which directly impacts what decisions they make about whether they:
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