Lesson 8 – Currency Correlations in Forex Markets
Forex traders, or at least successful forex traders, know that it is key to understand something called currency correlation.
This is when there is a relationship between two or more currency pairs that is not random. Which is to say, when one currency pair moves, the other will likely move with it.
However, this does not necessarily mean that the two correlated currency pairs will move in the same direction.
There are three theoretical main types of currency correlation, which are:
Perfect Positive Correlation
This means that every time a currency pair moves, the second correlated pair will move in the same direction 100% (due to the ‘perfect’ correlation) of the time.
Perfect Negative Correlation
This means that every time a currency pair moves, the second, negatively correlated pair will move in the opposite direction 100% of the time.
Zero Currency Correlation
This means that there is no correlation at all between the two currency pairs. So their relationship is perfectly random.
What does this mean for us forex traders?
As always, more knowledge leads to better decision making. Therefore a higher likelihood of being able to develop a more profitable trading strategy to make more money.
In forex, its possible to trade two positions that cancel each other out. In the case that two currency pairs have a negative correlation with one another, then their trades in the same volume will counteract each other, and itll leave you with having paid the spread fees for nothing.
Conversely, if two trades are positively correlated, you may be unknowingly doubling your trade exposure by entering in two similar trades. This is not a risk management best practice. As this premise could turn out to be wrong then you’ll find yourself behind for more than you’d have planned for.
This is known as being overexposed.
And finally, you can use the knowledge for correlated currency pairs to hedge your positions to mitigate risk. This is a very useful, advanced strategy that almost all investment banks use to lower the risk of them losing money on a trade. We will go into depth on this later in the course.
Currency Pairs with a Positive Correlation (usually)
- EUR/USD and GBP/USD
- EUR/USD and AUD/USD
- USD/CHF and USD/JPY
Currency Pairs with a Negative Correlation (usually)
- EUR/USD and USD/CHF
- GBP/USD and USD/JPY
- GBP/USD and USD/CHF
Please remember that these are not laws of the market, correlations change over time, and it is always important to stay up to date and to make one’s own conclusions after looking at the data.
Another key area where it is important to take note of correlations are certain commodities, and how they are currently to some currencies, especially if the related country is heavily reliant on the export of that commodity.
So, if a particular industry takes a hit and it impacts the value of this commodity, the correlated currency will likely move in the same direction. And vice versa.
The two most famous and obvious examples of this are:
- The Australian Dollar and Gold
- The Canandian Dollar and Oil
Knowing which commodity or which stock markets health is tied to which currency can give traders an advantage by helping you understand why the market moves the way that it does.
And thus, if you begin to recognise patterns, you will be able to find profitable trades regularly.