This is the Audio Version of the Blog Post
Entitled: How to Use Currency Correlation in Forex Trading
Originally posted on the Forex Training Group Blog
My name is Richard Davies, and I am the narrator for the Audio Version of this Blog Post
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.S. Dollar and the price of crude oil expressed
in U.S. Dollars. Conversely, a negative correlation exists between assets that typically move
in opposite directions. Such a negative correlation usually exists between the EUR/USD exchange
rate and the USD/CHF exchange rate, for example. 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. The
Canadian Dollar’s relative value is therefore positively correlated to the price of crude
oil. Conversely, the U.S. 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. Due to the market correlation of the individual currencies to
the price of crude oil, an upwards spike in the oil price would tend to negatively affect
the US Dollar to Canadian Dollar currency pair.
Currency pairs’ correlation arises out of the interdependence seen between currencies
due to their being priced relative to one another and traded in pairs. For example,
the Euro Pound currency pair is a derivative of both the Euro to US Dollar and Pound to
US Dollar exchange rates. Therefore, a trader that happens to take a long position in Euro
Dollar and a short position in Pound Dollar has essentially taken a long position in Euro
Pound, due to their long and short USD positions, which effectively cancel each other out.
Furthermore, the Euro Pound exchange rate is correlated to the exchange rate of both
component pairs versus the U.S. Dollar, being positively correlated to Euro Dollar and negatively
correlated to Pound Dollar. Forex Pairs Correlation: More About Positive
and Negative Correlation Forex currency pairs are made up of two national
currencies, which are valued in relation to one another. A number of different elements
directly affect the value between two nation’s currencies, such as the interest rate differential,
the balance of trade between both countries and whether the country is a commodity producer
or consumer to name just a few. 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.
For example, the correlation of Euro Dollar and Pound Dollar is positive because if the
demand for U.S. Dollars increases, the level of both currency pairs will usually decline.
Conversely, if the demand for U.S. 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. For example, a negative correlation exists between the
Euro Dollar and Dollar Yen currency pairs. When demand for U.S. Dollars increases, the
currency pairs often move in opposite directions, with Dollar Yen generally increasing due to
the U.S. Dollar being the base currency in the pair, and with Euro Dollar declining since
the U.S. 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. Changes
in correlation can occur daily in some forex pairs, which can in turn affect the accuracy
of a trader’s projections of long term correlations. Some of the reasons for variations in correlations
include changes in each nation’s central bank monetary policies, sensitivity to crude
oil or other commodity price fluctuations, and political and economic factors.
Importance of the Calculating Correlation in Forex Trading
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. If the trader takes a long position in Euro Dollar and another
long position in Pound Dollar of the same U.S. 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.S. Dollar, the Pound Sterling also tends to weaken versus the U.S. Dollar as well.
Hence, the overall risk assumed by the trader would be the rough equivalent of four percent
risk taken in either Pound Dollar or Euro Dollar.
Conversely, if the trader assumes a short position in Euro Dollar and a long position
in Pound Dollar, the risks inherent in each trade will tend to cancel out to a certain
degree due to the positive correlation of the two currency pairs. 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.
Calculating Correlation in Forex Currency Pairs
Correlations between currency pairs are inexact and depend on the ever changing fundamentals
underlying each nation’s economy, central bank monetary policy, and political and social
conditions. Currency correlations can strengthen, weaken or in some cases, break down almost
entirely into randomness. In the financial world, correlations are typically
quantified and displayed in a forex correlation table using a scale that varies from +1 to
-1 where: • 0 is equal to no correlation. Hence, two
currency pairs having zero correlation implies that the two pairs will behave in a completely
random and independent manner from each other. • +1 is equal to a fully positive correlation
and implies that two currency pairs will generally move in the same direction 100 percent of
the time. • -1 is equal to a negative correlation,
which means that the two currency pairs will generally move in opposite directions 100
percent of the time In between these extremes we can categorize
correlations as per the following: • +/- 0.0 to 0.2 – Very weak correlation,
movements are essentially random • +/- 0.2 to 0.4 – Weak or low correlation
of little significance • +/- 0.4 to 0.7 – Moderate correlation
• +/- 0.7 to 0.9 – Strong to high correlation • +/- 0.9 to 1.0 – Very strong correlation,
movements are related to each other Utilizing Correlations in Forex Trading
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.
Risk managers overseeing forex risks for large corporations with operations in many countries
often use a forex correlation chart to determine how to best hedge the company’s foreign
exchange exposure. When applied to the company’s different foreign operations, such a currency
correlation chart can help show a risk manager how to best offset their company’s foreign
exchange exposure by using forwards, futures and option trades.
Forex Trading Strategies Involving Correlation Forex traders make use of a number of strategies
using correlation. One such strategy involves two strongly correlated currency pairs such
as Pound Dollar and Euro Dollar. 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.S. Dollar is strengthening overall,
Euro Dollar should begin to sell off. At that point, a decline seen in Pound Dollar would
confirm the U.S. Dollar downtrend, with a decline in Aussie to US Dollar further confirming
the Dollar down move. 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. For example, instead of buying two Pound Dollar contracts,
the trader could buy one Pound Dollar contract and one Aussie to Dollar contract, since those
pairs are both positively correlated, although imperfectly. The imperfect correlation allows
for lower risk exposure and adds diversification to the trader’s portfolio due to the Australian
Dollar being substituted for the Pound Sterling in one contract.
Inherent Risks in Using Correlation in the Forex Market
Since the 2008 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 Australian Dollar, Canadian Dollar and New
Zealand Dollar. Another recent event that took the entire forex market by surprise was
the Swiss National Bank’s move to end its self-imposed floor on the Euro’s exchange
rate against the Swiss Franc in January of 2015. 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.
While sudden changes in correlations can present significant risks when trading currencies,
the sudden changes can also be used to a trader’s advantage. 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. Understanding how the various currency pairs relate to each other
and why some pairs move in tandem while others diverge significantly allows for a deeper
understanding of the forex trader’s market exposure. 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.
This concludes the Audio Version of the Blog Post Entitled:
How to Use Currency Correlation in Forex Trading Thank you for listening.