I don’t know if you’ve ever heard of the correlation, but just in case I’ve been working on this article. Have you ever thought that all operations appear to be positive or negative at once? This is because you are possibly unknowingly doubling, tripling, or simply pushing your account to the limit without knowing it.
Understanding the Currency Correlation
Speaking of correlation what we tend to think is when and how prices fluctuate. And more specifically how prices move in relation to each other. This is the main idea of correlation. How does the EUR/USD move with respect to GBP/USD?
Types of Correlations
Currency pairs can be correlated both positively and negatively, let me explain what I mean. A pair of splits can be correlated in a positive aspect if its values move at the same time and in the same sense. For example, you can see this in the GBPUSD and EURUSD pairs, this is because when the GBPUSD is quoted then the EURUSD is also quoted.
The correlation is negative if there are two or more currency pairs operating in opposite directions at the same time, i.e., simultaneously. You can also see this in the case of the USDCHF and the EURUSD, because when the first pair is negotiated, then the second one falls, and the same happens on the contrary.
Correlations Are Not Constant
It’s important to know that correlation can change, because of global economic sentiment and factors, their dynamism, or any market event. This means that the correlations we find in the market, it is not important how strong, may not align with the long-term correlation between two currency pairs. The changes present in the correlations are usually based on antagonistic monetary policies, also the sensitivity of commodity prices to a currency pair…etc.
Forex Strategies and Correlation
The effect of the correlations is vital and significant in the market, therefore as a trader, you should take into account your operation based on it. I explain to you, in periods of high market uncertainty, strategies are usually used that rebalance your portfolio by replacing a few assets that become positively correlated with other assets that have a negative correlation with each other.
When this happens, the asset price movements are mutually canceled and your account risk is reduced. However, their returns are also reduced. A simple way to look at it is to take a stock that would gain value as the price of value dropped.
Important Aspects of Correlation and Forex Trading
With correlation, you can assess the risk to which your trading account is exposed. In the event that you have purchased several currency pairs that have a strong positive correlation, then you will be facing a greater directional risk.
Through correlation, you can also cover or diversify your own exposure to the foreign exchange market, plus if you have a directional bias with respect to a particular currency, then you can diversify the risk if you start using two pairs that are positively correlated. Although I don’t recommend this because if you lose the correlation you can mess it up.
Commodities, Foreign Exchange and Correlation
Commodities also correlate with currencies. You may already know this but:
-There is a positive correlation between oil and the Canadian dollar (I hope you haven’t forgotten what that means) as Canada is a major oil-producing country.
-The Australian dollar and gold are positively correlated by Australia’s imports of this precious metal.
However, gold and the US dollar have a negative correlation. Since when the USD loses value in the classic periods of inflation then investors look for an alternative reserve currency and the most traded is gold, as it acts as a safe haven value.
These examples also give you a look at how correlations are given on different assets in the market.
How Correlation Coefficients are Calculated
Correlations between currency pairs are always inaccurate and are often constantly changing. Because they depend on prices, the correlation in the foreign exchange market also depends on the economy, the monetary policy of the central bank, and the political and social conditions that correspond to each nation. But the correlations can be quantified and done through a scale that varies from +1 to -1:
0 or close to zero means no correlation. This means that two pairs that do not have a correlation will not have similar behavior and their behavior will be independent of the other.
+1 or a close value means that two currency pairs will move in the same direction.
-1 or close, negative correlation. These currency pairs will move to the opposite side 100 percent of the time.
Forex Correlation Calculator
There is a formula for calculating this:
ρxy = cov(X,Y) / σxσy
But don’t worry, I’ll leave you three portals where you can consult it:
An overview of currency seasonality: https://www.mataf.net/es/forex/tools/correlation
A very complete correlation table: https://www.myfxbook.com/es/forex-market/correlation
Here you can see the correlation of one currency to the other assets: https://es.investing.com/tools/correlation-calculator
How to Read the Table
I recommend consulting the correlation in forex in extended periods of time, because in 5 min for example is not the most appropriate unless you are going to exploit a specific strategy. A good idea is to view it in a daily time frame. If the correlation is very close to +1 or -1 between two pairs you see, consider it or try to avoid it if you are operating in those pairs.
Risk of Correlation in the Forex Market
Socio-political problems cause currency pair correlations to undergo sudden changes. The devaluation of oil and commodity prices has also made the previously weaker correlations stronger in certain currency pairs involving commodity currencies.
Sudden changes in correlations can usually present significant risks in the foreign exchange market and that this has affected the traders who based their trading systems on this. If they exploit this type of inefficiencies it is basic to have concrete points where to leave the position or undo it.
Importance of Correlation for Traders
For you as a trader, studying the asset correlation closely gives you a broader knowledge of the market, since you can understand the allocation of assets that seek to relate those that have a negative or low correlation and thus could reduce the volatility of your trade.
In addition, if you are a beginner trader, you will be able to establish greater control of your operation and your account will not be so exposed. Here you can have an important added value.
Correlation and Cointegration
Many times people confuse cointegration with correlation, which we were explaining earlier. With cointegration, you can identify the degree to which two currency pairs are sensitive to a particular exact price during a specific period. Cointegration goes one step beyond correlation and measures the distance between the ratio of two or more active persons and the time that they are maintained.
Cointegration as well as correlation must also be calculated. It is easy also, the greater the degree of cointegration between two currency pairs, then the probability of maintaining a constant distance grows. Being objective, identifying, and calculating the correlation is easier.
Pros and Cons of Using Correlation
Some positive and negative aspects of using correlation by trading in the currency market:
– Easy visualization and calculation of the correlation using a scale -1 and 1.
– Capacity in ample spaces of time to be able to diversify the risk.
– In the correlation you can see the strength of a relationship, however, you will not be able to obtain information about whether the relationship is cause-effect.
– The correlation cannot predict the future behavior of the market.
[Extra] How to Trade with Currency Correlations
To the point, Ruben. I know how it goes, but how can I do it if I’m starting my operation? Well, a very simple way is for you to diversify by currency. For example, if you are thinking of trading in the currency market do not trade for example EUR/USD, EUR/CAD, EUR/AUD.
In the previous case, you will be very exposed to the euro (EUR). It is better to diversify more or better, for example, EUR/USD, GBP/USD, and EUR/GBP. We now have 2 EUR, 2 GBP, and 2 USD. We have a portfolio composed of different currencies although a priori EUR/USD and GBP/USD may be correlated.
It’s a very simple and basic way to start applying it now.