What is Currency Correlations? And How To Use It In Forex Trading
What is Currency Correlations? And How to Use It In Forex Trading
Trading Forex requires great knowledge of technical indicators and fundamental events. Although most traders tend to focus on one of the aforementioned approaches, today, more and more attention is being paid to proper trading psychology and risk management.
Currency correlation is strongly connected with risk management, and can help you to better understand the market when trading. Understanding of the correlation between currency pairs can help you avoid overtrading.
What is Currency Correlation?
It is simply a measure of how similarly one currency pair moves in comparison to another. When pairs move in the same direction, they have a positive correlation. If they move in the opposite direction, we observe a negative correlation between them. A perfect correlation occurs when pairs move in the same direction, which is extremely rare. Additionally, we say that correlation is high when pairs move in almost the same direction.
Just as an example, let's say that the EURUSD goes up 500 pips in a month.
During that same month, let's say that the GBPUSD goes up 1,000 pips. We are not too concerned about how many pips the pairs moved but how similar the moves were. If the prices went straight up, then they are highly correlated.
If the EURUSD went straight up and the GBPUSD stayed in a range then shot up, they would be less correlated. When they move in the same direction at the same time, up in this case, they are positively correlated.
Negative correlation is when one pair goes up and the other goes down. In this example, if the EURUSD went up at approximately the same time the GBPUSD was going down and to a similar degree, then there would be a high degree of negative correlation.
How does this us help as traders? If there is a high negative or positive correlation, there may be times when one pair moves before the other highly correlated pair and can serve as a forecast or a confirmation of a move in the pair we are trading. In addition, you might want to stay away from taking trades that are two highly correlated because that increases your risk that the same move will affect all your trades in a similar fashion.
Correlation Trading Tips
Bear in mind that correlations do change, and past performance is not always a guaranteed indicator of future correlations. However, this information can be used to develop your own currency correlation strategy, to minimise your portfolio's exposure. Here are some tips to consider:
Avoid positions that cancel each other out: If you see two currency pairs that move in opposite directions nearly all of the time, you should realise that holding long positions in both of those currencies mitigates any potential gain that could be had.
Diversify with minimal risk: By investing in two currency pairs that are almost always positively correlated, one can mitigate risks over time, while maintaining a positive directional view.
Hedge exposure: Losses can be minimised by hedging two currency pairs that hold a near-perfect negative correlation. The reasoning here is simple. If you hold a position with a currency pair that loses value, the opposing currency (which has a negative correlation to that pair) will likely gain, albeit with a lower final value. While such a strategy won't completely mitigate losses, those losses will very likely be reduced.
There are many tools which you can utilise through metatrader which can help you with currency correlations, we at myfxmentor use a currency strength meter which we have created on Metatrader as an EA. If you are interested in understanding more on the advantages of using currency correlations and currency meters, feel free to contact us on info@myfxmentor.com
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Risk disclaimer: The information presented on our blog are for educational and entertainment purposes only. Nothing on this website serves as investment advice or recommendations. Trading is risky and you can lose more than your initial investment. MyFxMentor cannot be held responsible for any decisions visitors make. Please consult a financial advisor before making any investment decisions. Risk disclaimer.
