Understanding Currency Correlations

by Hass67
All the currency pairs are interrelated in the forex markets. They keep on affecting each other. As a forex trader, you need to understand that the price action of each currency pair is not mutually exclusive.

Most of the currency pairs move relative to one another. Understand that different currency pairs are correlated. These correlations can be positive or negative.

Knowledge of how strong this relationship is and its direction can help you in developing your trading strategies with a new perspective. This has the potential to become a great trading tool for you.

Correlations are numbers ranging between +1 and -1 that are calculated based on past pricing data between different currency pairs. These numbers can provide you with information that can maximize your trading returns, minimize risk and help avoid counter productive trading.

Lets use an example to make it clear. Suppose USDJPY and USDCHF has a positive correlation of +0.83 last month. This number is close to +1. It indicates that both pairs move together most of the time in the same direction.

So, if you are trading USD/JPY and USD/CHF at the same time, it will double up your position if you take long positions or short positions on both simultaneously. What it means is this that if you lose a trade on USD/JPY, the chances are that you will also lose the trade on USD/CHF 83% of the times.

Take another example. Suppose EUR/USD and USD/CHF have a negative correlation of -0.9 in the past month. Both the pairs are moving in opposite directions. If you go long on one, it is not a good strategy to go short on the other. It will only double up your position and increase your risk.

While investing in two currency pairs simultaneously, try to choose such pairs that have correlations close to zero. Zero correlation means the two pairs are almost independent of each other and mutually exclusive.

Always keep this in mind that currency markets are constantly changing. The correlation between currency pairs also keep on changing. It would be a good idea to calculate the correlations between pairs on a monthly basis.