Using Correlation To Optimize Profit Potential In Forex

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Currency correlation or forex correlation is a statistical measure of the degree to which the value of currency pairs are related and will move together. If two currency pairs rise at the same time, this represents a positive correlation, while if one appreciates and the other depreciates, this is a negative correlation.

Using Correlation To Optimize Profit Potential In Forex

Understanding and monitoring currency correlations is important for traders as it can affect their level of risk when trading in the forex market. In this article, we will look at how forex correlation is determined and calculated, how it affects trades and trading systems, and what tools can be used to track currency correlations.

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A foreign exchange correlation is the connection between two currency pairs. There is a positive correlation when two pairs move in the same direction, a negative correlation when they move in opposite directions, and no correlation if the pairs move randomly with no discernible relationship. A negative correlation can also be called an inverse correlation.

Currency correlation is important for traders to understand because it can have a direct impact on forex trading results, often without the trader’s awareness.

As an example, suppose a trader buys two different currency pairs that are negatively correlated. The gains in one can be offset by losses in the other, which is often used as a hedging strategy. Meanwhile, buying two correlated pairs can double the risk and profit potential, as both trades will result in a loss or a profit. They are not completely independent as the pairs move in the same direction.

A correlation coefficient represents how strong or weak a correlation is between two forex pairs. Correlation coefficients are expressed in values ​​and can range from -100 to 100, or -1 to 1, with the decimal representing the coefficient.

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Anything in the negative range of -100 means the pairs are moving almost exactly the same but in opposite directions, while above 100 means the pairs are moving almost exactly the same in the same direction. “Almost identical” is an important distinction to make because correlation only looks at direction but not magnitude. For example, one pair may move up 100 pips (percentages in points) while another moves down 70 pips. Both pairs may have a very high inverse correlation, even though the magnitude of the move is different.

If a reading is below -70 and above 70, it is considered to have a strong correlation, as the movements of one are largely reflected in the movements of the other. Readings between -70 and 70, on the other hand, mean that there is less correlation between the pairs. With forex correlation coefficients close to the zero mark, the two pairs show little or no relationship with each other.

Although this formula looks complicated, the general concept is that it takes data points from two pairs, x and y, and then compares them to average readings within these pairs. The top part of the equation is the covariance and the bottom part is the standard deviation.

For example, think of the data points as closing prices for each day or hour. The closing price of x (and y) is compared to the average closing price of x (and y), so a trader can enter closing and average values ​​in the formula to draw how the pairs move together. To obtain the average it is necessary to track multiple closing prices in a program such as a Microsoft Excel spreadsheet. Once multiple closing prices are recorded, an average can be determined, which is continuously updated as new prices come in. This is plugged into the formula along with new values ​​for x.

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The following table shows the correlation between some of the most traded currency pairs around the world. You can compare each currency on the y-axis to those on the x-axis to see how they relate to each other. For example, the correlation between the EUR / USD and GBP / USD ​ is 77, which is quite high.

Although the pairs will not always move in exactly the same direction, they mostly move together. In comparison, the GBP/USD and EUR/GBP ​ have a strong negative correlation at -90, meaning they move in opposite directions much of the time.

Monitoring currency correlations is important because, even in this small table of currency pairs, there are a number of strong correlations. A trader could unknowingly buy the GBP/USD and sell the EUR/GBP thinking they have two different positions, for example. However, because the pairs have a high negative correlation, they are known to move in opposite directions. Therefore, it is likely that the trader will win or lose on both, as they are not completely independent trades.

Correlation allows traders to hedge positions by taking a second trade that moves in the opposite direction to the first position. Currency hedging is achieved when gains from one pair are offset by losses from another, or vice versa. This can be useful if a trader does not want to exit a position but wants to offset or reduce his loss while the pair pulls back.

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For example, the EUR/USD and AUD/USD share a strong positive correlation in the table above, which is 75. Buying the EUR/USD and selling the AUD/USD creates a partial hedge. It is partly because the correlation is only 75 and correlation does not account for the magnitude of price movements, only direction.

In the case of the GBP/USD and EUR/GBP, there is a negative correlation. Therefore, buying or selling both creates a hedge. Buying the GBP/USD will make money if the GBP/USD rises, but those gains will be offset by the long position on EUR/GBP falling due to the negative correlation.

Commodities or raw materials also have correlations with each other as well as currencies. In the table below, the data shows that gold (XAU/USD) had little correlation with other major currencies during this timeframe. However, it notes that it shares a strong positive correlation of 81 with silver (XAG/USD). For someone who trades gold and holds positions in other currency pairs, this type of analysis is important.

For example, it is worth noting that natural gas does not share a high correlation with any currency pairs, or with precious metals such as gold or silver. Meanwhile, crude oil (WTICO) also does not show a high correlation with currencies, but often has a correlation with the USD/CAD and CAD/JPY. This is because Canada and Japan are major oil importers.

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Commodities can hedge or be hedged by currencies when a strong correlation is present in the same way that currencies hedge each other. A commodity can move much more in percentage terms than a currency, so gains or losses in one may not be fully offset by the other. Read our commodity guides on oil trading and gold trading.

Trading pairs involves looking for two currency pairs that share a strong historical correlation, such as 80 or higher, and taking long and short positions on the assets. A trader can buy the currency that is moving down and sell the currency pair that is moving up. The idea of ​​this is that they will eventually start moving together again, given their long history of high correlation. If this happens, a profit may be realized.

However, there is a danger that the pairs will not go back to being properly correlated. Therefore, some traders may place a stop loss order on each position to control the loss. There is also a risk that the loss on one trade is not offset by a gain on the other, leading to a loss, even if the pairs move back to their previous correlation. Ideally, the bought pair would move up and the sold position would move down as the pairs meant to return, which could lead to a profit on both trades.

When using any currency correlation strategy, and any strategy, position size is a key element of risk management. Based on where the stop loss is placed, many traders choose to risk a small percentage of their account, for example, if the stop loss is reached. For example, if the stop loss is 30 pips in the EUR/USD (with a USD account), taking a micro lot position means there is a risk of $3 on the trade (30 x $0.10). For that $3 of risk to equal just 1% of the account, the trader would need to have at least $300 in the account. In this way, the risk on the trade and the risk to the account is controlled.

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Currency pairs are uncorrelated when they move independently of each other. This can happen when the currencies associated with each pair are different, or when the currencies in question have different economies.

For example, the EUR/USD and GBP/USD both contain the US dollar, and the Eurozone and Great Britain are closely related economies.

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