To become a consistent forex trader, you need to understand how sensitive your entire portfolio is to the volatility in the forex market. This is important because forex currencies are traded in pairs. You should know the correlations of the different currency pairs and the way they change over time. Once you know them, you can use them to your advantage and to help manage you overall portfolio’s exposure.
It can be easy to see the relationship between currency pairs once you know what to look for. If you are trading the GBP/JPY pair for instance, you are actually trading an offshoot of the GBP/USD and USD/JPY pairs. Thus, GBP/JPY will be fairly linked to either one or both of these currency pairs.
Yet, the correlation of currency pairs is not just because they occur in pairs. Although a few currency pairs will shift in the same direction, some currency pairs move in opposite directions. What this indicates is that multiple factors are involved. In this article we will look at currency correlations and ways in which they can be used to our advantage when trading forex online.
How to read currency correlation tables
Currency Correlation is the numerical estimation of the relationship between two currency pairs. The correlation coefficient normally varies from -1 to +1. A correlation of (+1) means that the currency pairs have strong positive correlation and always shift in the same direction all the time. A correlation of (-1) indicates that the currency pairs have a strong negative correlation and would always shift in the opposite direction. A correlation of (0) indicates that the currency pairs relate to each other in a random manner, thus the correlation is weak.
Calculating correlation in currency pairs
Correlations between currency pairs are approximate and depend on the ever shifting fiscal policies of different countries central bank as well as political and social factors. Currency correlations can become strong, weak or occasionally randomized.
The currency correlation table below clearly shows the correlation between numerous currency pairs for intervals of 1 hour to one year:
Every figure in the cells of the above currency correlation table stands for the correlation coefficient. They are calculated using the exchange rate of the currency pair given in the column straight up to the left and the exchange rate of the EUR/USD currency pair across time intervals represented in the resultant straight row on top of the table.
You’d also observe that the entire correlation coefficient is represented in color. The red color shows that there is a positive correlation between the currency pairs while blue color shows a negative correlation.
When the currency correlation is represented in red apart from showing that it is positive correlation, it shows that the currency pairs are moving in the same direction. What this means is the exchange rate of a particular pair increases, the exchange rate for the second pair increases as well.
On the other hands, negative correlation illustrated in blue shows that the two currency pairs are moving in the reverse directions.
The classes of figures illustrated below will give you a clearer understanding of how to interpret the values of the correlation tables.
- 0.0 to 0.2 – shows an extremely small correlation, where the two pairs move in a random manner
- 0.2 to 0.4 – shows an insignificant small correlation.
- 0.4 to 0.7 – shows an average correlation
- 0.7 to 0.9 – indicates a strong to sky-scraping correlation
- 0.9 to 1.0 – signifies an extremely strong correlation and where the shifts of the two currency pairs are similar to each other.
Currency correlations change
The forex market has highs and lows. It is not constant but changes all the time. Despite the fact that there could be either weak or strong correlations between currency correlations for some days, some weeks, months, or some years, it is not at all a guaranteed that they’d continue to remain the same. They do change and often times, this change occurs when you are not anticipating it.
Strong currency correlations for a month may change to a weak one next month and vice versa. See the correlations in this table:
Try to match up the coefficients for a particular currency pair across the diverse period of times. What did you observe?
The USD/JPY currency pairs changed constantly, and vary from one time frame to the other.
What you can learn from this is that currency correlations are never constant. They do change often. Another thing you can learn is that they can change by a great value within a short period of time as you’d observe from EUR/USD during the first month and the third month period. That’s a huge value sway!
Due to the recurring shift of sentiment of the forex market, always try to know the present currency correlations.
For instance, across a one week interval, the correlation between the currency pairs USD/JPY and USD/CHF was 0.22. That value is a very small correlation coefficient and signifies that the pairs have an inconsequential correlation.
Nevertheless; when you view the three-month data for the smear interval, figure jumps to 0.52. Afterwards it rose to 0.78 for 6 months and eventually settles to 0.74 for one year.
This correlation shows that the currency pairs flopped and crumble in their long-time relationship. A formally positive correlation became a a weak correlation in a short-interval period.
Take a look at the currency pairs EUR/USD and GBP/USD. This is a good indication of the degree of change that can happen between a currency pair. The one-week period shows a very strong correlation with a 0.94 coefficient! However, this correlation seriously flopped in the 30-day period. It flopped to 0.13, and afterwards got better again for another three-month period to a good figure of 0.83, and topple again to a frail correlation within the next six-month sprawling intervals.
Let’s examine the correlation between the currency pairs USD/JPY and NZD/USD in the table below:
The correlation coefficient of the currency pairs for the entire year was -0.69.
This shows a reasonable to a well-built correlation. However, if you examine the correlation for a month period, you’d observe that the correlation coefficient basically tumbled.
There are a lot of reasons why currency correlations change. Some of these reasons are the altering interest rates of a country, a change in a country’s fiscal policies, any assortments of financial or political occurrences that affect the sentiments of traders on that particular currency.
Forex trading & currency exposure
The success of a forex trading strategy is greatly affected by the global change in currency exchange rates. It’s significant for investors to reflect on the influence the foreign exchange market will have on their trade. Forex traders have currency exposure due to the transaction risk suffered by businesses engaged in international trade. Currency exposure is the risk that forex rates will be altered after they have entered financial agreement.
How to use currency correlation to manage exposure
Having known the meaning of currency correlation and how to interpret the figures, we will discuss in this section, how you can use the correlations to manage exposure. Proper knowledge of how correlation works can help you to avoid entering two positions that contradict each other.
Take for example, if you know that these two currency pairs EUR/USD and USD/CHF are moving in the reverse directions roughly hundred percent all the time, you’d observe that when you extensively trade on EUR/USD and USD/CHF, you practically have no place. This is so because the correlation shows that when the EUR/USD unites, USD/CHF will experience a selloff.
In contrast, when you hold EUR/USD and AUD/USD or NZD/USD for an extended period of time, it is related to replicating the same position due to the fact that they are strongly correlated.
Another thing you need to take into account is the spread or diversification. Given that the EUR/USD and AUD/USD correlation is commonly not hundred percent positive, you can make use of these currency pairs to spread your risk a bit even as you still maintain a central directional outlook.
For instance, if you want to convey a bearish stance on the USD, rather than purchase two tons of the EUR/USD, you may be better off purchasing only a single lot of the EUR/USD and then one lot of the AUD/USD currency pair. The defective correlation between these two currency pairs helps you to spread and greatly minimize your risk.
You can as well make use of varying pip or point figures to your benefit. For instance, let’s make use of the currency pairs the EUR/USD and USD/CHF one more time. The two currency pairs have roughly hundred percent negative correlations, but the price of a pip move in the EUR/USD is 10 dollars for a batch of one hundred thousand units even as the price of a pip shift in USD/CHF currency pair is 9.24 dollars for the equivalent number of units. This signifies that you can make use of the USD/CHF currency pairs to hedge the exposure of the EUR/USD currency pairs.
This is how you can use the USD/CHF currency pair to hedge. If you for example have a trade portfolio with one small EUR/USD batch of one hundred thousand units and one small USD/CHF batch of one hundred thousand units, if the EUR/USD currency pair shift by ten points, your position would plunge to 100 points. Nevertheless, due to the fact that USD/CHF shifts in alternating direction to the EUR/USD, you’d gain a lot from the short USD/CHF currency position. It will probably additionally move almost ten pips to roughly 92.40 dollars. This would greatly reduce your risk and the loss that would have been 100 dollars to -7.60 dollars. Of course, this hedge also means smaller profits in the event of a strong EUR/USD sell-off, but in the worst-case scenario, losses become relatively lower.
Whether you want to spread your positions or discover additionally currency pairs to leverage your outlook, it is highly significant that you know what correlation exist between different currency pairs and their trends of movement. This is very influential in forex trading if you have a thorough knowledge on how to apply it to trade successfully. When you know it, it would assist you to spread, hedge and manage your trades.
Currency correlations conclusion
To succeed as a forex trader long term, you need to understand how the various currency pairs are correlated with one another. This will help you to know what your overall risk exposure would be and as confirmation for trading signals. A number of currency pairs move together with each other, whereas other currencies may move in opposite directions. The knowledge of currency correlation assists traders to manage their portfolios and positions more efficiently. Regardless of your trading strategy and whether you are looking to diversify your positions or find alternate pairs to leverage your view, it is very important to keep in mind the correlation between various currency pairs and their shifting trends.
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