A correlation can be positive - when the prices of two currency pairs move in the same direction - or negative, when the prices of two currency pairs move in opposite directions.
Forex traders need to understand the relationship between currency pairs because they can affect a trading account's exposure and risk.
Currency pairs are based on two economies
Currency pairs consist of two different currencies that are evaluated with respect to each other. Each currency belongs to an economy, so this can affect the supply and demand for the currency. When the value of a currency changes, it increases (or decreases) against all other currencies, not just against one. This means that currencies cannot be traded separately.
However, this does not mean that the value of a currency will change at the same rate against all other currency pairs. For example, if the euro appreciates against the US dollar by 50 pips, it will not necessarily increase by 50 pips against the Australian dollar, but there is a strong likelihood that the EUR will appreciate against the Australian dollar to a certain degree.
A positive correlation means that two currency pairs move in the same direction. To illustrate this, consider the example of the EUR/USD and the AUD/USD.
The EUR/USD consists of the euro and the US dollar. If the price of the EUR/USD decreases, it either means that demand for the euro is decreasing or that demand for the dollar is increasing. Both scenarios lead to a depreciation of the EUR in relation to the USD.
If the price of the EUR/USD is decreasing due to a strengthening dollar, the price of the AUD/USD will also likely decrease. This is an example of a positive correlation between the EUR/USD and the AUD/USD.
A negative correlation means that two currency pairs move in opposite directions. To illustrate this, let's use the EUR/USD and the USD/JPY pairs as an example.
If demand for the dollar increases, the price of the EUR/USD decreases and that of the USD/JPY rises. The strength of the US dollar will be displayed on the charts as a drop in the price of the EUR/USD and an increase in the price of the USD/JPY.
Trading several currency pairs
Traders need to take into account the correlations of different currency pairs if they wish to trade multiple parities.
Currency correlations can increase the overall risk of a trading account.
Suppose a trader decides to risk 2% of his account on each trade and he initiates a long position on the EUR/USD with a 2% risk and a long position on the GBP/USD with a 2% risk as well.
The correlation of these two currency pairs is strongly positive (80% on average), so if one currency pair moves in one direction, there is an 80% that the other parity will move in the same direction. This therefore means that the actual risk is 4%, since the trader is risking 2% on each trade.
Correlated trades can cancel each other out
If a trader initiates a long EUR/USD position and a short GBP/USD position, one position will produce a profit and the other one a loss. Initiating opposite positions on currency pairs with a strong positive correlation is counter-productive. The effect is the same as with pairs that have a high negative correlation (such as the EUR/USD and the USD/JPY) when a trader initiates two long or two short positions.
Correlations can be measured
Correlations between currency pairs are never perfect. Depending on fundamental factors, an exchange rate correlation can become stronger or weaker, it can also reverse itself during economic crises.
You can use a table of correlations (click here) between currency pairs to measure their strength.
Example of correlations during 1 day:
Example of correlations during 1 week:
You will notice that the EUR/USD had a positive 77.1% correlation with the AUD/NZD on one day, but over a longer period of one week, the correlation is negative at -24.8%.
Traders can use this kind of table to determine the correlations within the timeframe they use for trading.
Using forex correlations to your advantage
Forex correlations can provide traders with an edge, since observing a currency pair can provide a glimpse of how another one will act, when they are correlated.
A correlation can be used to confirm a trade or an analysis. The idea is to see if pairs with a positive correlation are moving in the same direction as a currency pair you are watching. For example, if you see a currency pair moving downward, you can use other positively correlated pairs to see if they are also falling in price.
For example, let's say that you see the EUR/USD rebounding on a support level and you are considering a long EUR/USD trade. To confirm your analysis, you can look at pairs with a positive correlation such as the AUD/USD and the GBP/USD to see if the prices of these pairs are also experiencing a similar rebound. If this is indeed the case, it means that the movement is probably due to a fundamental factor and your trade has a good chance of succeeding.
1 - The EUR/USD is in a downtrend, but the pair is bouncing slightly on a support level.
2 - GBP/USD confirms the rebound.
3 - At the same time, the AUD/USD is breaking past the last high and confirms the likely continued rebound.
Avoiding false signals
Correlations can also be used to help you avoid bad trades, for example: by identifying a false break.
If you observe a break to the upside, you can use positively correlated pairs to see if they are doing the same.
Let's look at another example with the EUR/USD, AUD/USD and GBP/USD pairs.
1 - The AUD/USD's downward trend reverses.
2 - Meanwhile, the GBP/USD moves in the opposite direction and continues its downward trend.
3 - The EUR/USD also does not show a bullish reversal.
You can see that even though there is a reversal of the AUD/USD's trend, the GBP/USD and EUR/USD pairs do not confirm this rebound. You can also see that after a very short time, the AUD/USD's price fell and followed the trend set by the other two currency pairs. By observing the correlations, you can avoid bad trades! You can even initiate a short AUD/USD position to bet on a recovery of the positive correlation.
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