Forex currency correlation is the relationship between two currency pairs. A correlation of 1 means that the two currencies are perfectly correlated: if one goes up one point, the other will also go up one point. The negative correlation of currencies shows a negative relationship: if one currency pair goes up, the other pair goes down.
A correlation of 1 means that the two currency pairs are perfectly correlated, a correlation of -1 means that the currency pairs have a perfect negative forex pair correlation.
Does forex trading require a great deal of knowledge about trading indicators and investment strategies? Although most traders tend to focus on technical analysis or fundamental analysis, nowadays you also have to pay attention to trading psychology and money management.
A forex correlation is a very interesting analysis to do and should be part of your money management. Understanding currency correlation is very important today for a trader who wants to win in the stock market.
This article explains what currency correlation is, how to understand it, and ultimately how to improve your trading strategy by adding correlations between different forex pairs.
What is Currency Correlation?
It's easy to see why currency pairs are interrelated. If you trade the British pound against the Japanese yen (GBP/JPY), you are trading an offshoot of the GBP/USD and USD/JPY; both GBP/JPY currencies share a relationship with the US dollar and are correlated with the dollar.
While zero correlation denotes that the relationship between the currency pair is completely arbitrary.
It is important to note that the correlation coefficient is a statistical measure that does not mean that there is a causal relationship between the two variables. It can be observed over time that the currency pairs are correlated, it does not mean that there is necessarily a causal relationship between these correlations.
Changes in Forex Correlation
It is obvious that in forex there are correlations between different currencies. This is why knowing the correlation between different currency pairs is essential. Few brokers offer trading tools to see the correlation between currencies, yet professional traders at major banks use software that provides this information.
If one wishes to make an effective trading strategy and protect a portfolio or simply have a global picture of one's trading portfolio, it is important to track forex correlations.
Global economic factors are dynamic - they can and do change daily. Long-term correlations between currency pairs provide a clearer picture of the relationship between forex pairs. There are many reasons for a change in the relationship in forex. The most common are monetary policies, the sensitivity of certain currency pairs to commodity prices, as well as political and economic factors.
Currency and Commodity Correlation
A very good trading strategy is to use the correlation between currencies and commodities. Are you wondering what the relationship is between these assets? Some countries make a good part of their income from the export of commodities. In this case, the price of their national currency depends on the price of the commodity.
In this situation, we have developed countries like Australia and Canada, but the vast majority of emerging countries, like Russia or Brazil. When trading the Russian ruble, one cannot avoid looking at the price of oil, as a large part of the federal budget is derived from oil exports.
When you want to trade the currency pairs of these countries, you simply cannot miss the correlation. This is also the case with the Australian dollar. This is why you should choose a trading platform that has a commodity currency correlation tool, such as MetaTrader Supreme Edition.
Forex correlation calculator - currency correlation tool
The ideal way to strengthen your position is to calculate your correlation yourself. It seems complex, but it is simple. Use a spreadsheet, like Microsoft Excel and you can calculate the correlation. Download the historical daily currency prices and import them into an excel table.
You can then use the function in excel =CORREL (range1, range2). The most complete view of forex correlation changes is rendered using one year, six months, three months, and one-month data.
Although the relationships between forex pairs change, it is not mandatory to bring your numbers up to date daily. However, it is a good idea to update them once a week or once a month at least.
Each country has a different monetary policy in a different cycle, so changes in forex correlations may appear.
How to Use Forex Currency Correlation in Trading?
If you want to make money in the stock market you need to do some money management. Looking at the volatility and relationship between different financial instruments like forex and commodities is a key to successful trading.
Why are forex pairs correlated? It's quite simple. If you trade currency A against currency B, you are trading a derivative union of these currencies against the US dollar. While the reasoning is easy to understand, the behavior is not always so direct. Some pairs may move in tandem, while others may move in opposite directions.
The first step in understanding these changes is to look at a forex correlation chart. This chart shows the relationships between currency pairs over time. Knowing how certain financial instruments have performed in the past can give you trading ideas and analysis to make and can help you predict future market movements.
For example, strong positive correlations show an active link between the value of one currency pair against another.
Tips for Trading with the Currency Correlation Chart
Keep in mind that forex relationships do change and past performance is not always a guaranteed trading indicator of future correlation. However, this information can be used to develop your forex correlation strategy to minimize your portfolio's exposure to forex volatility that you can avoid.
Avoid positions that cancel each other out. If you see forex pairs moving in opposite directions almost all the time, you should avoid taking a position in one of them, because gains on one pair will be losses on the other.
Diversify your investment. Trading tools and especially the correlation calculator can help you avoid taking unnecessary risks. Be careful not to take too many positions on perfectly correlated currency pairs: in this case you increase your risk: if you are right on your trade you can be happy because you are a winner on all pairs, but if you make a wrong decision, it will be a loser on the other currency pairs too.
Forex hedging. Losses can be minimized by hedging currency pairs that have an almost perfect negative correlation. The reasoning is simple. If you have a position with one currency that is depreciating, the other currency, which is negatively correlated with the first one will probably be appreciating.
Hedging is a very good strategy for limiting losses, but it can limit gains as well because when you make gains on one currency pair, you lose on the other.
Trading Strategies with the Forex Correlation Chart
To trade on forex correlation there is no set trading strategy in advance, as correlations between currencies and with commodities change all the time.
Certainly, trading strategies based on forex correlation have developed with the internet age and the growth of computer power to make calculations. For example, 35 years ago it was very difficult to do this kind of calculation easily. However, in recent years it has become quite common to trade currency pairs for diversification reasons: up to 20 pairs with a correlation between -0.2 and +0.8.
This is also known as correlation trading. In this way, a trader tries to profit from the past market on multiple assets. The idea behind this approach is to eliminate any loss orders as quickly as possible. This way one can usually receive minor gains in a short period.
It is important to keep an eye on the currency correlation tables, as the correlation can differ greatly. For example, currently, the EUR/USD is correlated with EUR/GBP -1 on a one-hour chart, while the correlation over a year is 0.94. This is why currency correlation trading should only be done with a clear understanding of what the correlation is and how you can profit from it.
There are a few things you need to do before you can start trading forex. First, you need to consider a set of assets. The general rule here is quite simple - don't get into pairs that you know absolutely nothing about.
As with all other trading strategies, you need to have an overview of potential market movements. Building a trading portfolio can take time and it would be a mistake to jump into several assets without knowing them.
Long-term trading in forex is an expensive strategy. In forex, there are swaps, financing fees that reduce your profitability. This is why it is more interesting to trade short-term when you have a trading strategy based on the correlation between currencies. Long-term correlation can be used as a trading indicator and to confirm investment decisions.
Once you have a better overview of correlations and their possible impact on price, start investing. We suggest you start with the demo forex account first. The main idea would be to open around 10 positions immediately. Try to analyze forex pairs with negative correlation first. Then, when you see price movements, identify the direction of the stock market and remove losing positions from your portfolio.
A good tip to give here is to use a trailing stop loss, this will help you secure your gains. We hope you have enjoyed this article on currency correlation trading. Now it's time to try it out, open a demo account, and try to put this theory into practice.
No comments:
Post a Comment