Currency pair correlation is an essential concept that can help make your trading activities in the foreign exchange (forex) market more successful. However, the concept requires a thorough understanding in order to determine the right time to enter and exit the market as well as the right strategies to employ. Although having automated forex trading software can make your trading life easier, it’s still best to understand forex correlation, related concepts and their implications in order to enhance your knowledge and be able to manage your risks much better.
1. Know the concept of correlation and their implications
Currency correlation basically refers to the relationship of two separate forex pairs. A positive correlation means that the two forex pairs move in sync in the same direction while a negative correlation means that the pairs move in opposite directions.
While it may sound easy to trade and gain profits in the forex market based on correlations, you could also double your losses if your forecasts are wrong or if your hedging strategies are ineffective.
2. Understand that the strength of forex correlations is constantly changing
Correlation coefficient is a numerical range that measures the strength of correlation between two forex pairs. It ranges from 1.0 (perfect positive correlation) to -1.0 (perfect negative correlation) with 0 indicating that there’s no relationship between the 2 pairs.
This generally uses the Pearson correlation coefficient formula. Most traders also use this equation in calculating and creating their forex correlation analysis on computer spreadsheets.
Bear in mind that the forex correlation strength depends on a variety of factors including the time of day when the market opens in both countries and the trading volume in the markets of both currencies. This also means that the values differ when calculating the forex correlation strength on a monthly, quarterly, bi-annual and annual basis.
Having a correlation table can help you analyze the short-term and long-term trends of a forex pair’s correlation coefficients against other forex pairs over specific time periods e.g. monthly, semi-annual and annual. Some trading companies provide daily data that traders can use to create their custom correlation table on computer spreadsheets.
Alternatively, you can use forex auto trading software to avoid the hassle of manually formatting your correlation table. An automated trading system basically keeps track of forex trends and timely sends notification to inform you of lucrative opportunities.
3. Double your success with positions in 2 highly positive correlated pairs
Entering long positions on two forex pairs with positive correlations of 100% or closer can potentially earn you better profits once the prices increase considering that those pairs move in the same direction. In essence, you’re simply doubling your earnings if the trade is successful.
Examples of forex pairs that typically have positive correlation are:
- AUD/USD and NZD/USD
- EUR/USD and AUD/USD
- EUR/USD and GBP/USD
- EUR/USD and NZD/USD
- USD/CHF and USD/JPY
4. Go short when one of the highly positive correlated pairs is expected to fall
When one of the two forex pairs with highly positive correlation starts to fall, it’s a good idea to go short because the other pair will most likely follow the trend soon.
5. Diversify your portfolio by holding positions in 2 positively correlated pairs
You can enter positions in at least 2 forex pairs that move in the same direction even if they’re not 100% positively correlated. In this way, you diversify your portfolio while maintaining a core direction in your trades as well as manage your risks to as low as possible.
For example, to react to the bearish outlook on the USD, you might want to hold a position in each AUD/USD and NZD/USD pair instead of two positions in AUD/USD alone. The monetary policies and biases of central banks differ from country to country, so when the USD rallies, one foreign currency may not be as affected as the other.
Having automated forex trading software allows you to receive real-time alerts when lucrative opportunities in your watchlist are available, and thus, enabling you to take immediate action.
6. Avoid entering positions in 2 highly negative correlated forex pairs
By entering 2 positions of forex pairs with a correlation of almost -100%, you’re basically canceling your investments out. In short, it’s just like you’re not having any position at all because when the value of one pair increases, the value of the other decreases by the same value.
Examples of forex pairs that are typically negatively correlated are:
- USD/CHF and EUR/USD
- USD/CAD and AUD/JPY
- USD/JPY and AUD/USD
- GBP/USD and USD/CHF
- GBP/USD and USD/JPY
To keep track of your favorite forex pairs without confusing their relationships, invest in dependable forex auto trading software that can provide you real-time alerts on great trading opportunities.
7. Hedge your forex pairs to minimize risks
The concept of hedging in forex trading is simple: If your current position exposes you to adverse movements in the market, it’s wise to open additional positions that will offset or balance that existing position in an effort to minimize risks.
For example, the USD/CHF and EUR/USD are historically known to have an almost perfect negative correlation. So if you’re actively holding a long position in EUR/USD, you might want to open a long position in USD/CHF to offset or hedge any losses from your existing trade.
Another hedging strategy is to open a position that’s opposite of your active trade on a positively correlated forex pair. For example, the EUR/USD and GBP/USD are historically positively correlated. If you actively hold a long position in EUR/USD, and such a forex pair is expected to break its positive correlation with GBP/USD, you might want to minimize your losses by opening a temporary short position on GBP/USD.
8. Invest in the right trading tools and opportunities to increase your chance of success
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