One of the first things that you should know in Forex trading is that currencies are traded in pairs. And no single pair is entirely independent of another pair being traded in the market. Wonder why?
Because, all the currencies in the world are interlinked to one another and a change in one can lead to change in all the others, to some extent or the other. So if you are aware of the currency correlations and how they keep shifting, you can use that knowledge to control your Forex portfolio in a better way. To be an effective Forex trader, it is important to understand how sensitive or tolerant your portfolio is to market volatility.
Currency Correlation in Forex Market
In financial terms, correlation can be defined as the statistical measure of the relation between two currency pairs. The coefficient of correlation ranges between -1 and +1, where -1 value indicates perfect non-correlation while +1 indicates perfect correlation, That is to say, two currency pairs with a correlation of 1 will move in parallel 100 percent of the time, while two pairs with a correlation of -1 move in opposite directions 100 percent of the time.
The correlation between two pairs can be read and understood using a correlation table, which both amateur and experienced Forex traders rely on to a great extent:
How to Use Currency Correlations to Your Advantage?
Take a look at the benefits that traders can enjoy by using currency correlation in trading:
Eliminate Counterproductive Trading Risk
Your knowledge of currency correlations and the ability to read correlation tables can help you eliminate the risk of counterproductive trading, where two trades cancel each other out. For example, the two pairs EUR/USD and USD/CHF move in opposite direction almost all the time. Now opening a long position in each of these would result in the trades cancelling one another, and the transaction becomes pointless. But when you know and understand the correlation between two currency pairs, you avoid such trades and reduce the risk significantly.
Predict Currency Behavior
When you understand how two currency pairs are correlated, you may even be able to determine the direction in which they would move and predict their behavior in the Forex market. Here, the basis for prediction would be the correlation table, and correlation between two pairs keeps changing constantly.
Also, the correlated pairs may not always move in the direction as they are “supposed” to. For example, the EUR/USD and USD/CHF which move in opposite directions, say 98% of the time, can move in parallel the remaining 2 percent of time (This could be for any political or economic factors that affect the movement of these currencies). In the example, let’s say that the value of Euro spikes and the value of CHF goes down for different reasons, while the USD remains more or less the same. In this case, you can use the correlation table to find and trade a currency pair that moves up due to this unusual movement, and profit from it.
Diversification of Risk
When you understand how two currency pairs are related and how the movement of one impacts the movement of another, you can trade two diverse pairs that move in parallel and leverage your position. Here, you need to look for pairs that have a very strong correlation, of say more than 0.7. By investing in diverse, yet highly correlated currency pairs, like the EUR/USD and AUD/USD, you are diversifying your portfolio and therefore minimizing the risk to an extent.
So the next time you are bullish on the USD, go for two short positions, one of EUR/USD and another of AUD/USD, rather than opening multiple short positions of EUR/USD. Similarly, you can take two currency pairs with a high negative correlation to hedge your risk and minimize losses. But keep in mind that hedging can also lower your profits.
Using currency correlation can help you leverage your profit or loss. For instance, when you know how two pairs are correlated, you can take positions that to double your profits. For instance, let us consider the pairs EUR/USD and EUR/GBP, which have a strong, positive correlation. The GBP/USD tends to follow the EUR/USD very closely. So taking a long position for each of these pairs is like going long twice on the EUR/USD, and leveraging your profits.
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