Currency Correlation in Forex

In the process of dealing with different currencies, it is important to take the correlation among them into account as it is the main driver of global capital flow and constitutes price fluctuations.

Market correlation and currency correlation

In finance, correlation is a statistical measure of how two different assets move in relation to each other. A positive correlation exists between assets that tend to move in the same direction. For example, a positive correlation is found between the value of Canadian Dollar against US Dollar and the price of crude oil expressed in US Dollar. In contrast, a negative correlation generally exists between assets moving in the opposite direction. Such a negative correlation usually exists between the rate of some currency pairs like EUR/USD and USD/CHF rate, etc. Currency correlation strongly affects the overall volatility of foreign currency pairs. Therefore, it is important to learn how to use currency correlation for every forex trader to manage currency risk in his or her trading account.

There are two main reasons why currency correlation is important for a trader:

1- To avoid entering a position with several related currency pairs at the same time, because this will increase the risk. In addition, trading positions on currency pairs that often move in opposite directions can be avoided at the same time.

2- To predict the direction of movement of a certain currency pair, through the signals seen on the currencies correlated with it.

The author will explain how that correlation can help, starting with 4 major currency pairs: EUR-USD; GBP-USD; USD-JPY and USD-CHF.

In the first two pairs (EUR-USD and GBP-USD), USD acts as the currency. Again, the first currency plays the role of goods and the second currency is the currency used to trade. That means when you buy EUR-USD, you pay USD to get EUR. In EUR-USD and GBP-USD, the currency that plays the role of currency is USD. Commodities of these two currency pairs are related to the two largest economies in Europe. These two currency pairs are so strongly correlated and almost all the time 99% they move in the same trend and form the same buy/sell indicators. Just recently, during the economic crisis, they have moved a little differently, but in terms of trends, they are still similar.

This means that when the EUR-USD pair shows a buy signal, the GBP-USD is also showing a buy signal with little difference in direction of strength and pattern. When analyzing the market, if you come to the conclusion that you should enter a short position with EUR-USD but at the same time decide to “go long” with GBP-USD, it means your analysis has a problem with at least one in two judgments. Therefore, it is said to enter a position only when you see both of these pairs showing signals in the same direction. Of course, when the signals show they are actually going in reverse (which rarely happens), it is a sign of buying and selling EUR-GBP.

Also, USD-CHF and USD-JPY behave similarly but not exactly in the same way as like EUR-USD and GBP-USD, because with USD-CHF and USD-JPY, the currency is different. The Swiss Franc and the Japanese Yen have many similarities as both belong to the group of oil consuming countries, but the volume of industrial business in Japan will make JPY different.

Normally, when you analyze 4 major currency pairs, if you see buy signals at EUR-USD and GBP-USD, you should see a sell signal at USD-JPY. If you also see a sell signal with USD-CHF, then your analysis is much more reliable. Otherwise, you must calculate and review your analysis.

EUR-JPY, GBP-JPY, AUD-JPY and NZD-JPY usually run in the same direction. It is just that their patterns differ from time to time.

The importance of currency correlation calculation in forex trading

The fact is that all forex trading involves currency pairs, so there can be a significant risk factor in a forex portfolio if the trader does not have an effective correlation management strategy. Essentially, any forex trader who holds positions in multiple currency pairs is actively involved in correlation trading.

The following is an example of how currency correlation can increase the risk of trading two currency pairs. Suppose an investor puts a risk parameter in their trading plan as 2% of their total account balance per trade. If a trader opens an EUR/USD long position and a different GBP/USD long position with the same US Dollar amount, it appears they have opened two buy positions with two percent risk per position. However, the two currency pairs have a positive correlation in practice, so if the Euro is weaker against US Dollar, British Pound also tends to decline against US Dollar. Therefore, the overall risk that the trader may incur would be equivalent to a four percent risk against either GBP/USD or EUR/USD.

Conversely, if a trader opens a short EUR/USD position and a long GBP/USD position, the inherent risk in each trade will tend to decrease to a certain extent due to the positive correlation of the two currency pairs. Entering an opposing position in currency pairs with a strong positive correlation can in general help improve the risk of each trade.

Calculate correlation in forex currency pairs

Correlation between currency pairs is not immutable that it can change depending on the fundamentals that are constantly changing in each country's economy, the central bank's monetary policy and other political and social elements.

In the world of finance, correlations are usually quantified and displayed in the forex correlation value using a scale from +1 to -1 where:

• 0: no correlation. Zero correlation of two currency pairs does not mean that they are independent of each other.

• +1: Two currency pairs have a positive correlation and will usually move in the same direction most of the time.

• -1: Two currency pairs have a negative correlation, meaning that the two currency pairs will usually move in opposite directions most of the time.

The forex affiliate trading strategy uses currency correlation

Forex traders use a number of correlation strategies, often in trading strongly correlated currency pairs such as GBP/USD and EUR/USD. The strategy is used in timeframes of 15 minutes or more. Forex traders wait for the correlation pairs to exit from correlation near major support or resistance levels.

Once two pairs have broken out of the correlation, one will tend to follow the other after a significant reversal. Accordingly, a trading strategy will be executed with a buy signal if either pair fails to make a lower low or a sell signal if either pair makes a higher high.

Traders in the forex market can also use correlation to diversify their portfolios. For example, instead of opening 2 buy positions on GBP/USD, a trader can open 1 buy GBP/USD and one buy AUD/USD order, since these pairs have a positive, albeit imperfect correlation. Imperfect correlation allows for lower risk exposure and diversification of a trader's portfolio due to the Australian Dollar being substituted for British Pounds in one trade.

How to choose the best currency pair to trade？

The best currency pair to trade is one with a small spread with strong and clear signals, which makes EUR-USD the best choice. GBP-USD is also similar to EUR-USD but it has a higher cost gap and also stronger momentum. USD-JPY and USD-CAD are completely different from EUR-USD and GBP-USD because they depend on two different countries. Japan and Canada have different positions and economies from Europe, GB and the USA.

Canada is an oil supplier, so the price of oil has a direct impact on the value of the Canadian dollar. That is why the oil price can be used as an indicator for the USD-CAD currency pair. When the price of oil increases, the USD-CAD will fall because then, the value of the Canadian dollar increases.

On the other hand, Japan is an oil consumer, so when the price of oil goes up, it has to pay more and therefore its products will be more expensive. As a result, the demand for their products will decrease, causing the value of the Japanese Yen to decrease. When the value of the Japanese Yen falls, in this case the USD-JPY increases, if the value of the USD falls again, it will be difficult to use the oil price to predict the direction of the USD-JPY.

CAD-JPY is a currency pair that is closely related to oil prices because Canada is the oil supplier while Japan is the oil consumer. So when the price of oil goes up, the CAD-JPY pair will plummet, and so on and so forth. Of course, countries can completely control their own currency by various means such as by changing the exchange rate. It means that a country like Japan will not be able to let its currency devalue too deeply for one reason because oil prices rise.

The AUD-USD pair has a close relationship with the price of gold. When the price of gold rises, so does the AUD-USD pair. So if we follow the situation of the gold price and the economy of the United States, we can predict the direction of the AUD-USD pair.

Another important example: If the EUR-USD rises and the GBP-USD falls at the same time, then the EUR-GBP rises very strongly. This is probably the most important case we can trade, given this basic logic.

It also happens that EUR-USD and GBP-USD run in opposite directions, then is the best time to buy and sell EUR-GBP. At this point, you understand why EUR-GBP does not usually have strong waves. This is because the EUR-USD and GBP-USD pairs are often moving in the same direction. For example, they rise at the same time and as such, EUR-GBP will not show any significant movement, because when the currencies of two currency pairs go up or down at the same time, the third relevant currency pair will not be able to get any clear movement or direction. I hope you already know why a currency pair goes up or down. It increases because the value of the first currency goes up, or the value of the second goes down. For example, EUR-USD would increases, if the value of EUR increases or the value of USD falls. If this happens at the same time, the EUR-USD will rise very strongly.

Using currency correlation helps forex traders to better understand portfolio management techniques, diversify, hedge risks, reduce risks and duplicate profitable trades. The above article provides essential knowledge about currency correlation as well as what it means in forex trading.