Correlation in finance is the statistical measure of how two different assets move in relation to each other. A positive correlation exists between assets that tend to move in the same direction. For example, a positive correlation is observed between the value of the Canadian Dollar relative to the U. Dollar and the price of crude oil expressed in U. Conversely, a negative correlation exists between assets that typically move in opposite directions.
Currency correlations strongly influence the overall volatility of — and hence the risk involved in holding — a portfolio of forex currency pairs. As a result, learning how to use currency correlation is a key element of currency risk management for any serious forex trader to understand.
To grasp the concept of forex correlation in currency pairs, the trader should first understand how market correlation affects the value of currencies. Because of the fact that Canada is a major oil producer, its currency can be directly affected by fluctuations in the price of crude oil. If the price of crude oil appreciates, the increase in the price of the commodity will generally make the value of the Canadian Dollar rise against other currencies.
Dollar tends to be negatively correlated to the price of oil due to the fact that the United States is a net consumer of oil on the world market. Forex currency pairs are made up of two national currencies, which are valued in relation to one another. Currency correlation occurs when the exchange rate levels of two or more currency pairs often move in a consistent direction relative to one another. This can be a positive correlation, when the price or exchange rate level tends to move in the same direction or a negative correlation, which occurs when the exchange rate level tends to move in the opposite direction.
Furthermore, a lack of correlation would occur if the currency pairs typically move independently in completely random directions over a certain period of time. Positive Correlation — When two currency pairs move in the same direction — so if one pair moves up, then so does the other.
Dollars increases, the level of both currency pairs will usually decline. Conversely, if the demand for U. Dollars falls, then the levels of both currency pairs will tend to increase. Negative Correlation — Negative correlation is the opposite of positive correlation, with the exchange levels of currency pairs usually moving inversely to each other. When demand for U. Dollar is the counter currency in that pair. Because of the dynamic nature of world economics, changes in forex correlated pairs do occur and make the calculation of correlation between currency pairs very important to the management of risk in forex trading when positions in multiple currency pairs are involved.
Due to the fact that all forex trading involves pairs of currencies, there can be a significant risk factor in a forex portfolio in the absence of proper correlation management. Essentially, any forex trader taking positions in more than one currency pair is effectively taking part in correlation trading, whether they know it or not.
As an example of how correlation can increase the risk in trading two currency pairs, consider the situation where a trader has a two percent of account balance per trade risk parameter in their trading plan. Dollar amount, it would appear that they have assumed two positions with two percent risk for each. Nevertheless, the two currency pairs are strongly positively correlated in practice, so if the Euro weakens versus the U.
Dollar, the Pound Sterling also tends to weaken versus the U. Opening opposite positions in currency pairs that are strongly positively correlated can be something of an imperfect hedge, since the overall risk of the portfolio is reduced. Currency correlations can strengthen, weaken or in some cases, break down almost entirely into randomness.
The currency correlation table shown below for illustration purposes was computed on April 19 th , It can be used to quickly gauge the correlation between several different currency pairs for time frames from one hour to one year: Furthermore, each correlation coefficient is color coded, where red indicates a positive correlation between the currency pairs and blue indicates a negatively correlation.
A positive correlation shown in red means that the currency pairs tend to move in the same direction. In other words, when the exchange rate for one pair goes up, the exchange rate for the other pair also typically goes up. A negative correlation shown in blue means that the two currency pairs tend to move in the opposite directions.
The correlation coefficient for two exchange rates is generally calculated using the following mathematical formula: Excel has a correlation function that can be entered into a cell of a spreadsheet as follows: You can then list the time frames horizontally along the top row of the table, such as one month, three months and six months. Varying the time frame of the correlation readings tends to give a more comprehensive look at the differences and similarities of the correlation between currency pairs over time.
Below are the individual steps you can take when setting up your correlation spreadsheet: As mentioned previously, when trading more than one currency pair, a forex trader is either knowingly or unknowingly involved in forex correlation trading.
One way of applying a forex correlation strategy in your trading plan is by using correlations to diversify risk.
Instead of taking a large position in just one currency pair, a trader can take two smaller positions in moderately correlated pairs, thereby somewhat reducing their overall risk and not putting all of their eggs into one basket.
By the same token, the forex trader could establish two positions in strongly correlated pairs to increase their risk, while also increasing potential profits if the trade is successful. Using correlation in forex trading also makes a trader more efficient, since they would tend to avoid holding positions which might ultimately cancel each other out due to negative correlation unless they wanted to have a partial hedge.
Forex traders make use of a number of strategies using correlation. The strategy is used in a time frame of 15 minutes or more. The forex trader waits for the correlated pairs to fall out of correlation near a major support or resistance level. Once the two pairs have fallen out of correlation, one pair will tend to follow the other after a significant reversal.
Accordingly, a possible trading strategy would be to generate a buy signal if one of the two pairs fails to make a lower low or a sell signal if one of the pairs makes a higher high. Other trading strategies might involve confirmation of reversals and continuation patterns using strongly correlated currency pairs. For example, if the U. A variation on the above strategy might involve avoiding entering into a trade if two other strongly correlated currency pairs fail to confirm the reversal or continuation pattern observed in the target currency pair.
Traders in the forex market can also use correlation to diversify their portfolios. Since the financial crisis, correlations for major and minor currency pairs have been in a constant state of flux. Socio-political issues, as well as sudden changes in monetary policy taken by central banks in some countries, have altered or reversed traditional correlations for some currency pairs.
In addition, the recent slide in oil and commodity prices has made previously weaker correlations significantly stronger in certain currency pairs involving the commodity currencies like AUD, CAD and NZD. The event significantly changed numerous correlations, albeit temporarily for some currency pairs.
The forex market is currently facing negative benchmark interest rates in Japan and the Eurozone, and a weak recovery in the United States as the Fed gradually raises interest rates. In addition, the market is dealing with a possible exit by Britain from the European Union and extreme volatility in the crude oil and commodities markets. Same direction positions in strongly correlated currency pairs can be used to compound profits and time entry and exit points, while opposite positions can be taken in strongly negatively correlated currency pairs to increase profits in the event of a major market move.
Essentially, being aware of currency correlations can only make you a better trader, irrespective of whether you are a fundamental analyst or technical analyst. Using currency pair correlation can also give forex traders further insight into established portfolio management techniques, such as diversifying, hedging , reducing risk and doubling up on profitable trades.
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