Using Currency Correlation For Better Trading
What is currency correlation, and why is it important?
Every single currency is related to other currencies because currencies are priced in pairs. On the other hand currency pairs also have "correlation" with each other. No single Forex pair trades completely independently from all others, because of the interdependence of various world economies. How one "currency pair" moves in relation to any other "currency pair" is identified as the correlation between those two pairs. While trading Forex, it is very important to understand and keep track of currency correlations, especially if we trade with multiple currency pairs.
Understanding currency correlation is a must for trading with multiple Forex pairs. It could be interesting to see how the correlation values change over the time. For this, please check Currency Correlation Tables to see if there has been any abnormal changes in the average correlation coefficients recently. The tables give a comparison of the values of past one week and the average of the past one year.
Correlations in Forex trading
Let’s say currency pair "A" moves in the same direction as pair "B", and we have been following pair A’s move very closely. We expect it to go up, and we buy. We have not been following pair "B" so closely, and suddenly, some negative news breaks out or some bearish technical signal suggesting that currency pair B might go down surfaces. Considering the bearish signal, we short-sell pair "B". What we did was neglect the fact that "A" and "B" generally move in the same direction, and now we are left with a long position for one pair and a short position for the other pair. Even if we make profit with one position, the other position may result in a loss and thereby cancel the profit realized by the first position.
Once we know about the correlations, we can take advantage of the same to control and optimize our Forex portfolio’s exposure by avoiding conflicting positions.
Correlation value range
A correlation coefficient of +1 between any two currency pairs means that those two pairs always move in the same direction. Similarly, a coefficient of −1 implies that the two currency pairs always move in the opposite direction. A coefficient of 0 implies that the relationship between the currency pairs is completely random. In fact, all these three scenarios are ideal and practically impossible. We will have a coefficient in the range of −1 to +1, but not the absolute +1, −1, or 0.
Positive and negative correlation
Some currency pairs tend to move in the same direction and some in the opposite direction. This is mainly because of the interdependence of economies. For example, the British economy or the Swiss economy would be more influenced by the developments in the European Monetary Union. This means that the British pound or Swiss franc would tend to weaken when the euro is getting weaker or vice versa. Positively correlated currency pairs are those that tend to move in the same direction most of the time, and negatively correlated pairs are those that tend to move in the opposite direction.
Positively correlated currency pairs
A positive coefficient that is less than +1 implies that the currency pairs in question generally move in the same direction, but not always. A value closer to +1 means that the correlation is strong, and most of the time, the pairs in question move in the same direction. The following example is from the daily charts of EUR/USD and GBP/USD. It is clearly visible that when one currency pair is going down, the other is also falling, and when one is moving up, the other is also rising. This makes these two pairs have a strong positive correlation.
Positive Ccrrelation - Pair 1 (EUR/USD)
Positive correlation - Pair 2 (GBP/USD)
Negatively correlated currency pairs
A negative coefficient between 0 and −1 means that the currency pairs in question generally move in the opposite direction, but not always. A value closer to −1 means that the negative correlation is strong, and most of the time, the direction of movement is opposite. The following example is from the daily charts of USD/CHF and EUR/USD (i.e., two pairs with a very strong negative correlation). Because of economic interdependence, the Swiss franc tends to weaken when the euro falls and vice versa. In EUR/USD, the euro is the first currency, and when the euro becomes weak against the U.S. dollar, EUR/USD goes down. On the other hand, when the euro becomes weaker, the Swiss franc tends to weaken, and this makes USD/CHF move up. This makes these two pairs negatively correlated currency pairs.
Negative correlation - Pair 1 (EUR/USD)
Negative correlation - Pair 2 (USD/CHF)
Interpretation of the correlation tables
Some currency pairs may be strongly correlated, and some may have a weaker correlation, be it positive or negative. The pairs we need to watch are the ones that are strongly correlated, either positively or negatively. Currency pairs that have a strong positive correlation will tend to move in the same direction most of the time. The pairs that have a strong negative correlation will move in the opposite direction most of the time. Please note that volatility may be very different even if the pairs are strongly correlated.
Interpretation of the correlation coefficient values
Using correlations while trading with multiple currency pairs
Currency correlations are dynamic and keep changing with time. This is because even though the world economies may be interdependent, the direction of two economies as well as market sentiments cannot have absolute correlation. There will be times that correlations may weaken even between strongly correlated pairs and vice versa.
The main use of correlation is to avoid taking conflicting positions for currency pairs which tend to move in opposite directions, as explained above. Another way to use it is by checking on some temporary exceptional changes in the correlations from the average values. Let’s take the example of three pairs with strong positive correlations. Let's say that currency pairs A, B and C maintain an average correlation coefficient of 0.80 to 0.95. Suddenly we observe that one pair has moved out of this pattern and it's coefficient with other two pairs has dropped to 0.45. Now there is a very high probability that it will settle back in the normal pattern sooner or later. This gives us an buying opportunity for that currency pair. An example of this can be seen at this weekly currency correlation analysis. Another examples of the same can be seen at this report of changes in short term Forex correlations and also at another report talking about temporarily misaligned correlations of GBP/USD and EUR/USD.
We may come across various strategies for correlation trading, but the best use is in managing a multi-currency portfolio so that we do not enter trades that are in conflict with each other. Overall, as mentioned above, it is very important to keep an eye on the currency correlations when we trade with multiple currency pairs.
The following tables, including the graphical representations, show the recent Forex correlation values as compared with the coefficient during the past year. It may help in analyzing whether there is any sudden change in the current status as compared with the normal trend in the correlations. The following currency correlation tables and the graphical representations of the changes are updated every weekend.
You may also use the online Correlation Calculator to calculate the correlations for any currency pair, yourself.