Search ForexCrunch

Often, novice currency traders look at individual currency pairs as if they existed in a vacuum. However, the truth is that correlation plays a big role – often, one currency pair will rise when another one rises. In other cases, two currency pairs tend to move in the opposite direction to each other.

This is measured by a correlation coefficient, with 1 representing the two currency pairs moving in the same direction all of the time, and with -1 indicating that the two currency pairs always move in the opposite direction.

This becomes particularly important when managing risk. For instance, consider the case where you have open positions in two currency pairs. Assume that you have risked 3% of your capital on each of these positions. If the two currency pairs aren’t correlated, then you have two individual 3% risks, which is an acceptable risk management strategy.

However, if the two currency pairs are completely positively correlated – they move in the same direction all of the time – then your risk is really 6%. On the other hand, if they are completely negatively correlated – they always move in the opposite direction – then your risk approaches zero, but so does your profit potential.

A Guest Post by  FXTM

To a certain extent, correlations occur because we trade currency pairs. For example, if you trade GBP/JPY, then this is really like trading a combination of GBP/USD and USD/JPY. Therefore, it is obvious that there will be some correlation between the movement of GBP/JPY and the movement of these two other currency pairs.

However, often more complex forces are at play. For example, Swiss francs tend to strengthen when the euro strengthens. Therefore, when the EUR/USD pair rises, the Swiss franc usually rises against the US dollar as well. This means that the USD/CHF pair falls, and in fact the correlation between the two pairs can remain at close to -1 for extended periods of time.

However, remember that correlations can change. For instance, USD/CAD and USD/CHF remained highly correlated (0.95) for a long period of time before 2010. In other words, they tended to move up and down in tandem as investors moved in and out of the US dollar. However, the relationship started to break down in 2010, as strengthening oil prices gave a temporary boost to the Canadian currency, which is highly resource dependent.

Understanding correlations can help you to make better trading decisions. First of all, as previously mentioned, they can help you to avoid taking on bigger risks than you planned by avoiding highly positively correlated pairs. They can also help you to avoid positions where one currency pair cancels the other out. They are also useful for diversification – for instance, you could take a position in two currency pairs that generally move in the same direction but are more weakly correlated. This allows you to follow an overall trend while reducing risk.

Further reading:  5 Most Predictable Currency Pairs – Q3 2014