In Forex trading, Correlations play a major role in trade. Forex trading happens from international currencies from various countries and the Currencies are issued by central banks. The value of a currency has a direct impact on an economy, a country’s outlook, commodities, stock markets and people’s spending behavior. At the same time, currencies are affected by various factors such as inflation, interest rates, employment and so on.

In this article, We will explain what are correlations and how to use them and what to pay particular attention on.

Correlation in forex trading?

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

Correlation coefficient

Correlation, in the financial world, is the statistical measure of the relationship between two securities. The correlation coefficient ranges between -1.0 and +1.0. A correlation of +1 implies that the two currency pairs will move in the same direction 100% of the time. A correlation of -1 implies the two currency pairs will move in the opposite direction 100% of the time. A correlation of zero implies that the relationship between the currency pairs is completely random.

The Pearson correlation coefficient is the most used measure of currency correlations in the forex market, but others include the intraclass correlation and the rank correlation. In the context of currency correlations, the Pearson correlation coefficient is a measure of the strength of a linear relationship between two different forex pairs. Many traders will use a spreadsheet computer program to calculate the Pearson correlation coefficient, because the method for doing so manually is very complex.

How some traders magnify their risk exposure without knowing it

Let us suppose that the trader has $10,000 on a trading account. He or she takes the advice of professionals in the field and only risks $500 (5% of the Funds) in every single trade. So the trader has opened long EUR/USD, GBP/USD, and short USD/JPY positions. If one has no idea what a currency correlation is, then at first glance, this might seem like a well-diversified trading portfolio, with reasonable risk management. However, this line of reasoning ignores the dynamics of currency correlation. As mentioned before the coefficient for EUR/USD and GBP/USD is 0.94, at the same time both of those pairs USD/JPY have a very strong negative correlation between -0.87 and -0.92.

Essentially those three positions very often move towards the same direction. So instead of only risking 5% of the funds, in real terms, the trader risks 15% of the account and if things go wrong, the losses can be considerable. This is something to keep in mind, before opening several positions.

Positively correlated pairs can also be utilized in a different way. For example, a day trader might be looking for an opportunity to open a position with the AUD/USD pair. However, the economic data might be contradictory and there are no clear technical indicators. So it is very uncertain in which direction the market will go. In this case, he or she can take a look at the latest correlation data and take a look at those currency pairs and commodities, which have a high coefficient with AUD/USD. Therefore, looking at GBP/USD or Gold price might be more informative during this process of decision making.

How currency correlate with others?

• With other currencies. Currencies can correlate with each other, as in our example. We will observe the correlation of two currency pairs, which include one common quoted currency.
• With indices. This should be clear too. Changes in indices lead to changes in a particular currency. For example, we can recall that the US dollar correlates well with the S&P500 index.
• With commodity assets. Commodity assets include everything that countries export and import. These are oil, gold, coal, aluminum, etc. You have probably deduced that there is a strong correlation between the Canadian dollar and oil. A correlation is also observed between the Australian dollar and gold.

Conclusion

Typically, correlation is used to confirm the correctness of the analysis. You can observe the behavior of a particular currency pair and, based on it, draw a conclusion regarding the currency pair correlating with it. The more trades move in the same direction, the higher the likelihood of establishing a new trend, which means that the chances of a successful trade also increase. This way you get additional confidence regarding simultaneous trades.

Correlation double both your profit and your loss. Let’s consider an example of a positive correlation. For example, you risk 5% of your deposit and open trades in the positively correlating pairs EUR/USD and EUR/GPB. In this case, the total risk for these two trades will not be 5%, but rather 10%. However, the amount of profit will also double.

Open account now and trade to explore the correlation impact in trading.