Being able to understand how sensitive your positions are to market volatility and other assets through correlation, especially when it comes to Forex correlation, is essential to better control your portfolio’s exposure and get better results.
If you’re wondering what Forex correlation is exactly and why it matters when trading, let’s have a closer look at FX correlation, so you can discover a great way to take advantage of Forex currency pairs, all while reducing your overall risk.
A Forex correlation simply shows the degree of relationship between two currency pairs, meaning how they move compared to each other.
You can observe a positive Forex correlation if two pairs move in the same direction, and a negative FX correlation if they move in opposite directions.
Now that you know what Forex correlation is, you have to know how it is measured. It has everything to do with the correlation coefficient, which gauges the correlation between two numbers, ranging from -1 to 1.
If the Forex correlation coefficient is equal to -1, then it indicates a “perfect” negative correlation. If the coefficient is equal to 1, then it represents a “perfect” positive correlation.
If the correlation coefficient is equal to 0, then that means that there is no relation/correlation between the way two currency pairs move, they move completely independently of each other. The closer to 0 the coefficient, the weaker the correlation. On the other hand, the closer to -1 or 1 the coefficient, the stronger the correlation, whether it be positive or negative.
A great tool to use is a real-time Forex correlation table, as correlations do not remain stable. They change depending on different factors like the time of the day, the currency pair, the price of commodities, the tone of central banks, and the overall market sentiment, as well as the global economic health, for instance.
Knowing how one currency pair moves compared to another will certainly help you focus on the most promising currency pair associations to realize bigger profits, or hedge your Forex trades to reduce risk.
There are different ways you can use Forex correlations as part of your Forex trading strategies, or in creating a trading system.
Now that you’re aware of what Forex correlation is, the first thing you should do is to avoid entering into two long/short positions on currency pairs that are strongly negatively correlated, as they will “cancel each other out” (not to mention that you’ll pay twice the spread).
If you want to bet on two strongly (positively) correlated positions - which usually happens when two currency pairs have the same quoted currency, you have to know that you will double up on the same position, as the two currency pairs will move in the same direction. While this may result in a bigger profit, you will lose twice as much if you’re wrong.
Usually, traders will open two positions in the same direction if the correlation is positive, and two opposing positions if there is a negative correlation.
While some traders like to use this strategy, others prefer to diversify their portfolio, and knowing what Forex correlation is can greatly help them.
You should also be aware that some currencies are also correlated to the price of commodities.
This is especially true about currencies from countries that are net exporters, such as the CAD and the price of Crude Oil, the AUD and the price of Gold, Iron Ore, and Coal, the NZD with the price of dairy products and wool, or the JPY or CHF and the price of Gold (because these assets are often considered safe-havens).
Now that you know what Forex correlation is and how you can integrate it into your trading, how about registering an account to trade the Forex market with a live trading account in the Trading Cup contest to show off your trading skills?