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Currency correlation and how to use it

Author: Martin Moni
Martin Moni
All publications of the author

Any seasoned trader will have noticed a pattern of certain currency pairs to behave either in the same way or completely opposite. I noticed this some time ago and thought I’d stumbled onto something new, but it turns out it’s an actual phenomenon.

I was discouraged to find I hadn’t discovered anything new, and that this currency correlation was an actual thing, so I did some more digging and here’s everything you will ever need to know about it.

What exactly is currency correlation?

Let’s start at the root - the strength of a currency depends on the economy it represents, thereby a stronger economy makes the currency stronger and vice versa. Meanwhile, most countries’ economies rely on each other, and this makes their currencies related in some way.

For example, in the European continent, the UK and other European countries rely on each other because they trade various commodities to each other as well as services. Due to this, the strength of the sterling pound is affected by any changes in the economies of other European countries. This is why the Brexit poll affected Forex trading on the 23rd of June 2016 weakened the pound against the euro. Other similar relationships can be seen all over the world, and this is what creates a currency correlation.

Data about currency correlations is usually represented in the form of a chart with the intersecting points representing the correlation coefficient. Such a chart would look something like this:

The above chart represents the coefficient as a percentage ranging from -100% to 100%, others will range from -1 to 1. The only important point to remember is that the more the coefficient leans toward 100% or 1, the more the currency pairs are correlated on the positive side. On the other hand, if the coefficient leans more toward -100% or -1, then the pairs correlate on the negative side.

In the chart above, EUR/USD and USD/CAD pairs are negatively related while the USD/CHF and the EUR/JPY are positively related. Generally, you want to look for numbers close to the extreme ends, and figures close to 0 like those of the AUD/USD and EUR/AUD are not to be relied upon.

For pairs related in a positive way, their values will shift in the same direction. Therefore, when the value of the USD/CHF is rising, that of the EUR/JPY is also rising 85.6% of the time. On the other hand, when the USD/CAD is rising, the EUR/USD is falling 74.4% of the time, and those are great odds.

Once you know which currency pairs have a high correlation to each other, whether positive or negative, it allows you to predict with relative certainty how one is going to move relative to the other. So, if on your Forex charts online the EUR/USD is on an uptrend, chances are high the USD/CAD pair is on a downtrend. Such information is incredibly useful to you as a trader in many ways.

How to use this information

I like to think of the currency correlation charts as a cheat sheet that you can use to draw quick conclusions about how certain currency pairs will move against each other.

Let’s see how this works with an example, the EUR/USD and AUD/USD pairs are strongly related, 84.3% on the hourly chart as you can see in the image above. Thus, if I see an uptrend on the EUR/USD chart, I don’t have to study the AUD/USD chart afresh to know that the trend will also be heading up, and I can place a long position immediately. Some other benefits include:

Increasing profits

When your Forex broker offers you more than a hundred currency pairs to trade, it is not easy to study all of them in detail. With the currency correlation charts, though, you can have some idea about how pairs are moving without having to analyse them. Say, you have spotted a potential move on the USD/CHF pair and have just placed a trade, you can quickly shift to the EUR/USD pair and place the opposite trade because they have a strong negative correlation. In essence, you would be studying a single chart and making money on 2 or even 3 currency pairs with very little effort.

Simultaneous trading

Compared to fundamental analysts, technical analysts have to carefully analyse every chart using technical indicators before determining a good trading position. This can limit the number of trades you can make in a day, if you have to study every chart before placing a trade. Again, the currency correlation helps you to avoid a repetition of the chart analysis, thereby allowing you to place more trades at the same time.

Hedging risk

We all know that even with the most in-depth analysis of the charts, we sometimes get it wrong and end up losing. Now imagine you have a long position GBP/USD and after a few minutes you realize you were wrong. You can watch as the trade gets stopped out, or you can find a pair with a strong negative correlation to hedge the loss. Going long on the USD/JPY, which is negatively correlated, can provide the profits to offset the loss you just suffered. This hedge may not cover your entire loss, but it might minimize the hit your account takes. (Read more about hedging)

Confirming breakouts

If you use a pivot points strategy to identify when prices have reached support or resistance levels, currency correlations can assist you in confirming your predictions. Say, you find that the EUR/USD is around a resistance level and are not sure whether it’s going to breakout or bounce off the pivot point. Checking out other correlated pairs can help you do this. It will involve both positively and negatively correlated pairs.

The EUR/USD pair relates positively to the GBP/USD and AUD/USD pairs, so you can check whether these pairs are also at a resistance level. At the same time, the USD/CHF and USD/JPY pairs are negatively related to the EUR/USD, you should look for the opposite, whether they are at a support level. If all the data matches up, then you know you are onto something, otherwise, you would know it was only a fake-out. Therefore, the relationship of the currency pairs can help you to confirm your analysis and avoid getting into fake-outs.

What to remember about currency correlations

There are a few things to keep in mind before employing currency correlations into your trading strategy:

Correlations change

Currency correlations only offer a guide as to which currencies have strong positive or negative relationships, but these relationships change with time. If you look at the images below, you can see the correlation coefficient changing as you shift from one timeframe to another. This is something you should always be aware of if you’re going to include currency correlations into your trading strategy.

At this time, the USD/JPY and USD/HKD pairs were strongly negatively correlated, and the value of one pair would move opposite to the other.

However, if you look at the entire day, you would see that the pairs were consistently positively correlated, despite a few moments within the day when they moved opposite each other. If you had worked with the data from the 5-minute correlations throughout the day, then you can see how that could have worked against you.

With this in mind, it is important to have the latest correlation table so that you’re not working with the wrong data. You should check your Forex broker’s website for the latest correlation data, because they constantly keep these figures updated. Otherwise, you can perform a quick Forex broker comparison to find the one who offers this information.

Additionally, even the figures from a single timeframe will change from one week to the other. The charts provided above show correlation for this week, but the figures for the next week may be different. The coefficient changes for many reasons, among them changing economic policies in the countries involved in the pair. For example, a raise in interest rates in the US can change the way the US dollar relates to other countries. Other factors that influence the coefficient include changing political environments and market sentiment about the particular currency pairs.

Not too many eggs in one basket

Finally, like everything else about the Forex market, things don’t always go according to the plan, and sometimes even the currency correlation charts get it wrong. Knowing this, you should not place too many trades simultaneously just because the correlation coefficient tells you that the currencies move together. In case the prediction is wrong, you may find yourself with multiple losing trades that may put a huge dent on your capital. My advice is never to place more than 3 trades based solely on the currency correlation, and always remember to manage risk in case the prediction is wrong.

 

Before you employ currency correlation, you need to understand more about it, and this video will help you do that:

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