Correlation Risk in Forex: Why You Are Overexposed

Let’s assume you have five positions open in your trading account. You allocate 1% of your account for each trade and therefore think your risk exposure is small.

Unfortunately, if the trades start to move in the same direction, your risk exposure is biased, and it is a much higher number than you imagine. This is known as correlation risk. It is clearly a trap for various traders.

What Is Forex Correlation Risk?

As the name suggests, correlation risk is where multiple trades are reliant on the same set of market conditions and then start moving in the same direction. You may think that you are managing your risk exposure by trading multiple currency pairs. In reality, if those pairs start moving as a result of the same news, then you have made one big trade, not five small ones.

How Correlated Currency Pairs Work

You can actually predict that some currency pairs will move in the same or similar ways. A perfect example of this is the EUR/USD and the GBP/USD. Both pairs have the US dollar on one side, and, for that reason, when the dollar gets stronger, they will typically both fall.

If you are trading both pairs, you are in fact not diversifying Forex trades. You are making a larger trade against the US dollar.

Other pairs move in polar directions. The USD/CHF typically moves in the opposite direction to the EUR/USD. If you go long on the EUR/USD and long on the USD/CHF, the two positions largely work against each other and cancel much of your intended exposure. Rather than diversifying, you’ve mostly hedged yourself.

This shows how important it is to understand correlated currency pairs. The relationships among the pairs indicate the level of risk you may be taking on.

Why Position Sizing Fails Against Forex Correlation Risk

Newer traders are recommended to size their positions according to a fixed percentage of their account. This is good advice. However, the best way to size positions is when you are taking independent positions. The moment you are taking correlated positions, the math goes out the window.

Imagine the following: you take a position of 1% risk on the EUR/USD, 1% on the GBP/USD, and 1% on the AUD/USD. This equates to 3% risk. However, frequently, these currency pairs will move together, and during large dollar movements, they all may hit their stop losses at the same time.

The loss that you incurred will be close to a 3% loss, but it will feel like you lost 1% on each of the three positions. The loss is multiplied because you don’t expect it and because you haven’t made provisions for that type of loss.

People feel comforted because they think they have followed the rules. However, the rules on position sizing assume trades are independent. If you are taking correlated positions, you will quickly discover that the assumption is no longer valid.

Finding Overlooked Association in Your Portfolio

Identifying correlation in your portfolio doesn’t require complex tools. List your current trades. For each, answer one question: what currencies are on either side of the trade? If the answer contains the US dollar, then you have a potential problem.

Consider the news too. A single action from the Federal Reserve could impact dollar pairs in a similar fashion. If your portfolio is reliant on moves from the Fed, you are working with a fragile structure. One piece of news can impact all your open positions.

Use a correlation table, too. Many broker platforms offer tools, free or paid, that show how pairs have moved in relation to one another for the weeks or months prior. The ranges of correlation are dynamic, and should be checked frequently. Two pairs that were completely independent last month may have moved in sync this month.

How to Diversify and Beat Forex Correlation Risk

True diversification means utilizing trades that are independent of the same actions. This is more difficult than simply picking different pairs. You need pairs connected to different economies, separate central banks, and different market stories.

Returning to your dollar currency pairs, for example, you could hold a dollar pair, a yen pair, and a pair that consists of a commodity currency like the Canadian dollar. Each of these pairs will react to different forces.

A fall in oil prices will tend to weaken the pair that contains the Canadian dollar, while a yen pair often reacts differently, since Japan is a major oil importer. This diversification is more effective than adding to the number of trades you make.

You should also pay attention to the direction of your trades, in addition to the currencies you choose. Two unrelated currency pairs can create hidden risk if traded in the same direction during a broad market mood.

Managing Your Forex Correlation Risk Day to Day

Managing your correlation exposure doesn’t have to be difficult or time-consuming. Build a habit that only takes a couple of seconds. Before you open your next trade, look at your current trades. Ask yourself if your next trade adds risk or if it will just add more to the risk you currently have.

You can also establish your own personal trading rules.

• Choose to allow yourself to hold only a certain number of trades that are related to the dollar.
• Put a limit on how many trades you have that are short on the yen.

These quickly and easily maintain discipline. These will prevent you from making one huge risky trade without being aware of it.

Journaling is also beneficial. After losing streaks, reflecting on your trades is essential. Did multiple positions lose simultaneously, and if so, was it for the same reason? If the answer is yes, then multiple trades likely caused the same issue. Adjust your habits based on this.

In a Nutshell

Your position size tells part of the story but not the entire story. Correlation risk is evident, especially in trades where many of your holdings share similar currency, or trades that are all reactive to the same news event. Even the most seasoned of traders can easily fall into this trap if they become complacent with their process as well.

Allocate a time at least once a week to analyze your actively held trades as a collective rather than a singular process. Pay attention to uncovered interconnectedness. It will far outweigh the importance of position sizing.