Many people like the dynamics and complexity of the Forex (also known as the currency or foreign exchange) market.
However, if you want to succeed and thrive in this hectic environment, and eventually make a profit, you need to know the intricacies of it.
In this article, you will find out more about currency correlations and how to use them to your advantage.
Basics of Currency Correlation Trading
The main thing one needs to come to terms with is the fact that currencies are traded in pairs, therefore they depend on each other. These are also known as correlations. These correlations have certain patterns and one should spend time to study them in detail. Then you can start building your portfolio.
You trade the GBP/JPY pair. In this particular example, you have to know that actually you trade with two pairs of currencies: USD/JPY and GBP/USD. However, often the links between two currencies are not as obvious as in the example. There might be other factors and things to consider before using the pair.
What is a Currency Coefficient?
Simply said, currency correlation shows how much two currency pairs correlate – positively or negatively. We use a currency coefficient to express the degree of correlation. Below, you can see a correlation table.
The coefficient varies from +1 to -1. The closer it is to +1, the more positive the correlation. This means that these two currency pairs change in the same direction. The closer the coefficient to -1, the more negative the correlation – the pairs always move in opposite directions. Zero coefficient shows that there is no certain pattern in which the currency pairs react – they can either move in the same direction or the opposite.
How To Calculate Currency Correlation?
Currencies can be affected by a variety of factors – central bank policies, the global economy, local political and social issues, etc. Below you can find a table which shows the correlation between currencies for an hour, a day, a week, a month, three months, six months and a year.
Let's take the first currency pair, AUD/JPY, and discuss the example.
The numbers you can see on the table are actually the currency coefficient. In our case, we take the exchange rate of the AUD/JPY and compare it to the one of the other currency pair, which is EUR/USD for different periods – 1 hour, 1 week, etc.
In the table above, you will have noticed that the figures are in two colors – blue and red. This particular example shows a positive correlation in red, which means that the prices go in the same direction. The ones in blue indicated the presence of negative correlation, meaning that the exchange rates of the two currency pairs move in opposite directions.
Interpretation Of The Results
Now, let's try to understand these figures and what they mean. If the result is between:
- 0 – 0.2: the correlation between the pairs is insignificant; therefore, the exchange rates move randomly.
- 2 – 0.4: the correlation is not that small but is not strong either
- 4 – 0.7: there is an average correlation
- 0.7 – 0.9: shows that there is a strong correlation between the pairs
- 0.9 – 1: indicates that the two pairs correlate very strongly
Changes In Correlations
One of the main characteristics of the FOREX market is that it is highly volatile.
This, consequently, means that currency correlations might change over time. For instance, the correlation between a pair is positive for weeks and even months. However, this does not mean that next year this correlation will remain the same. Unfortunately, often investors do not anticipate the changes in these correlations and it's not easy to predict such occurrences.
Let's take a look at an example table:
As we can see in the table, we have different currency pairs compared to USD/JPY.
As it is apparent, the correlations in the table vary so much that sometimes they move in the opposite directions. This table shows that in one year, the correlation between two currency pairs changes significantly. It also shows that great changes might occur only in a week or two. For instance, look at the first column and see how the correlation has changed. In the first month, we have a strong positive correlation. In the third month, however, the correlation is strong but negative.
If you observe the second column (USD/CHF pair), we will notice that in the first week there was almost no correlation between the two pairs: just 0.25. With time, the correlation increased and in the 6 month it reached 0.84, indicating a very strong correlation.
Let's take a look and analyze another table:
Now, we have the EUR/USD currency pair compared to others.
The first column in blue shows that only within a month the currency coefficient can change by more than a point. During the first week, we can observe a strong correlation of 0.85. However, for the 1 month this correlation dropped dramatically to -0.27. Then for the three-month framework, it rose again to 0.42 and for the rest of the year (9 months) stood at and surpassed 0.8.
Why Do Currency Correlations Change?
As clearly shown in the previous paragraph currency correlations do change dramatically, and there are quite a few reasons for that.
The main one is the different interest rates central banks set. In addition, a country's financial matters and policies strongly affect a currency. We shouldn't forget all political and social tremors that also affect currencies, therefore their correlation.
What is Currency Exposure?
If you are reading this article, most probably you have become or want to become in the future a Forex trader.
To do so, you need to understand the basics of the Forex and the main factors driving it. All Forex traders have to deal with the so-called currency exposure if they want to make a profit and, eventually, avoid serious losses. Since currencies are exposed to many factors that affect their exchange rates, there is a serious risk stemming from currency exposure.
The Most Important Rules Of Currency Correlation Trading
In the previous paragraphs, the mechanism of currency correlations was clearly and easily explained.
Now that you know what it is, how it functions and what factors affect it, you can actually use it to your advantage and manage risk and move forward for the next steps – the most important rules of currency correlations trading.
Avoid Opposite Currency Pairs
A basic rule – avoid trading currency pairs that contradict each other.
For instance, the USD/CHF and EUR/USD pairs. If you go back to the last table in the article, you will see that these pairs pretty much all the time go in opposite directions. In practice, this means that you won't make a profit trading these pairs.
In contrast, when you hold EUR/USD and AUD/USD or NZD/USD for an extended period of time, you can use them due to the fact that they are strongly correlated.
Spread And Diversification
You can use currency correlation to hedge and manage risks of buying too many positions of the same currency pair and suffer possible negative consequences. As you already know, the EUR/USD and AUD/USD currency pairs have a strong positive correlation, you can use them to spread the risk.
You are waiting for a European Central Bank meeting that will affect the price of the EUR/USD pair. Instead of buying a hundred EUR/USD positions, you can do the following: buy some EUR/USD and also AUD/USD.
Remember, they are positively correlated. This is how you diversify your positions and mitigate potential losses.
To begin with, a pip is a small price movement in a currency pair. To show you how to use them, let's take again one example – the EUR/USD and USD/CHF currency pairs. Their correlation is very strong but negative. However, the pip move for one hundred thousand units of both pairs is very similar – $9-10. Therefore, you can use USD/CHF to manage the currency exposure of the EUR/USD pair.
Keep in mind:
The best protection against risk is knowledge. To use the above-mentioned tactics, you need to understand the broad market picture. These techniques can be only of additional help and support.
If you want to become a successful trader, you need to possess a profound understanding and knowledge of the global market.
Currencies are volatile and various factors affect them on a daily basis. The most important thing, however, is to know how the different currencies react to each other. This is where currency correlation comes in handy.
As you already know, in some cases they move in the same direction, in other – the opposite, while in third situations – there is no pattern whatsoever. Not only can you use currency correlation to help you make better trades but also can be used to manage your risk strategy.