Forex pair correlations may seem daunting, but a basic understanding of correlations can go a long way toward helping you to become a better trader.
In fact, not understanding forex pair correlations when trading can be disastrous, but by learning a bit more about correlations many pitfalls can be avoided… and possibly some additional strategies can be added to your forex trading arsenal.
What are Forex Pair Correlations?
A correlation is a measure of how much one currency moves with another. Correlations will run between -100 and +100, the former meaning they move in exactly the opposite direction, and the latter indicating they move in the same direction.
Assume you wish to know the correlation of the EUR/USD to the GBP/USD. Quite often these pairs will move in a similar fashion, although not exactly. If two pairs moves in a similar way they will have a + correlation. Therefore, the EUR/USD and GBP/USD may have a +70 correlation on an hourly time frame, +83 on a daily time frame and +86 on a weekly time frame.
When pairs move the opposite direction, they will have a – (negative) correlation. The EUR/USD and USD/CHF are often negatively correlated, and therefore may have a -87 correlation on the daily time frame for example.
A +100 correlation means two pairs moves exactly the same. A -100 correlation means the pairs move exactly opposite. A correlation of 0 (zero) or a small + or – number means the pairs have no real correlation and if they do move together it is more likely to be random than anything significant. Therefore, a correlation of +35 or -41 means for the most part the pairs do not have a strong correlation.
Correlations will change all the time, but it is important to be aware of them. The statistics on the Daily Forex Statistics are updated daily to reflect current forex pair correlations. The correlations are presented in a matrix as shown in the figure below, and are presented for hourly, daily and weekly data.
How to Use Forex Pair Correlation Data
Here are a couple examples of how you can use forex pair correlation in your trading, to manage risk or hedge positions.
If you have multiple positions that are highly correlated (positive value over 70) it means that the pairs move somewhat in tandem. This means you may be overexposed to one currency, even though the risk on each position is managed. For example if you are long the EUR/USD and long the GBP/USD, you may be risking more than you expect since the pairs are highly correlated. Same for if you are long the EUR/USD and short the USD/CHF. These pairs are often inversely correlated, so by being long one and short the other, once again this may expose you to more risk than anticipated since if one trade loses the other is likely to as well.
You can hedge a trade in one currency pair with a trade in another that has a high (above 80) number. Go long the EUR/USD and you can hedge with a short position in the GBP/USD; since the pairs are positively correlated positions much be taken in opposite directions (long and short). For strong inverse correlations, both postions must be the same to form the hedge, such as long and long, or short and short.
Just because two pairs are highly negatively or positively correlated does not mean they will “offset” each others losses when hedging. Since each pair may move a different amount (more or less volatile), volatility is another factor which must be considered when looking at hedging.