Why Understanding Forex Pair Correlations Is Important
A forex correlation is how one currency pair moves in relation to another. Some pairs move in a very similar way, others move in opposite directions and other pairs may have no relation to each other at all. If you take multiple currency positions at one time, knowing how your pairs act in relation to one another is key to understanding your real risk and profit potential. It is possible that you are taking on much more risk than you think (if multiple positions are positively correlated) or that any gains in one pair will be erased by a loss in the other (negatively correlated positions).
Forex correlation stats may seem daunting, but a basic understanding of correlations can go a long way toward helping you to become a better trader. It is also recommended all traders understand Forex Volatility Statistics.
What is a Forex Correlation?
A correlation is a measure of how much one currency moves with another. Correlations run between -100 and +100, with the former meaning they move in opposite directions to one another, and the latter meaning they move in the same direction.
The number between -100 and +100 shows the strength of the relationship. -100 shows two different pairs always move inversely to each other over the period being tested. On the Daily Forex Stats page you will find various resources (or links to resources) where you can test correlations over varying lengths of time and different time frames (such as hourly, daily or weekly data). A reading of +80 shows there is a very strong correlation between two currency pairs–they move in the same direction very often, but not all the time.
A +100 correlation means two pairs move in the same direction. A -100 correlation means the pairs move in opposite directions. A correlation of 0 (zero) or a small positive or negative number (such as -30 or +25) means the pairs have no real correlation and if they do move together it is more likely to be random than anything significant. Typically a correlation of -/+ 70 is significant and noteworthy, while -/+ 80 is a strong correlation (or strong inverse correlation if negative).
Correlations do not measure magnitude. For example, the USDJPY and GBPJPY have a +83.6 correlation based on the chart below. They usually move in a similar direction, but that does not mean they move the same amount. Based on volatility data (a separate stat shown on the Daily Forex Stats page) the USDJPY currently moves 87 pips per day, while the GBPJPY moves 134.7 pips per day. This is important when hedging and attempting to control risk, discussed later.
Correlations are constantly changing, usually at a slow pace. The exact numbers used in all these examples are subject to change on a daily basis. Always check for the newest correlation and/or volatility data. That said, certain pairs generally exhibit strong positive and inverse correlations to each other, even though the exact amount of correlation fluctuates over time.
Daily Forex Correlation Table – June 7, 2017
If we look down the EUR/USD column we see the EUR/USD has a strong inverse correlation of -92.9 to the USD/CHF. As one pair goes up the other will go down much of the time. The EUR/USD and GBP/USD usually share a significant or strong positive correlation, and at the time of this shapshot is +77.9.
Based on the chart there is no correlation between the GBP/USD and CAD/JPY: -10.8, for example.
The GBP/USD and the GBP/CAD currently share a very strong correlation (often move in the same direction) at +95.
Below are some guidelines and uses for forex correlation data.
How to Use Forex Correlation Data
If you have multiple positions that are highly correlated (positive value over 70) it means that pairs move somewhat in tandem. This means you may be overexposed to one currency, even though the risk on each position is managed. Using the table above, if you are long the GBPUSD and the GBPJPY, these two pairs share a +86.8 correlation. That means they often move in the same direction, which means you may be potentially over-exposed to the GBP, because if the one of these pairs drops the other is likely to as well, resulting in two losing trades.
You can hedge one currency pair with a trade in another that has a high positive or negative correlation. For example, you can take a long in the EURUSD and a long in the USDCHF; since they move in opposite directions, one position hedges the other. Be aware of which currency is listed first though. The EURUSD and the USDCHF move in opposite directions but it is because the USD is only the base currency in one of the pairs. If you are long the EURUSD and short the USDCHF, you end up with two short positions in the USD–double exposure. This can be good if it moves in your favor, bad if the USD moves against you.
Just because two pairs are highly negatively or positively correlated does not mean they will completely offset each others losses when you are trying to hedge. Since each pair may move a different amount (more or less volatile), volatility is another factor which must be considered when looking at hedging.
If you believe one currency will be strong, for instance the USD, you can buy the USD versus a number of other currencies that are somewhat or highly correlated. This will increase USD exposure, but each pair can provide will provide a different stop loss level (risk) and target (profit). If you don’t like the trade setup in one pair, you may be able to find a better setup in a different pair that is highly correlated. You get a similar trade but with a better set-up.
–When two or more pairs are highly correlated the correlation can be used as a confirmation for the moves which are occurring. For instance, if the GBPUSD makes a big move higher but the GBPAUD doesn’t (+94.2 correlation at time of writing), it could warn that the move higher in the GBPUSD will soon fail. Keep in mind though the GBPUSD pair will have its own trend that affects, and is affected by, the GBPAUD, and vice versa. Never rely on this exclusively though, because correlations fluctuate so two pairs diverging may not be anything to worry about, and may just be the correlation weakening.
Divergences from correlations are potential trading opportunities as well as possible warning signs that something significant is going on in one of the currencies. Pairs that diverge from long-term correlations may revert back and provide a trading opportunity, or it may signify a breakdown of the correlation.
Forex Correlation Summary
This is a brief introduction to correlations. If you trade forex regularly, it’s recommended that you monitor forex correlations as they may be affecting your trading without you even knowing it. If you tend to lose on a bunch of trades all at once, check the correlations. If have take multiple trades but the trades always seem to offset each other (you feel like you treading water, without making progress), correlations may also be an issue.
Refer to the Daily Forex Stats page for resources on correlation statistics. See how positively and negatively correlated pairs interact with each other. You may find that being aware of correlations can help you control risk, find alternative trading strategies and alert you to potential dangers or opportunities.
By Cory Mitchell, CMT
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