WHAT IS CURRENCY CORRELATION?
Currency correlation, also known as forex correlation, refers to the degree of connection between two different currencies. It provides valuable insights for traders by revealing how the prices of currencies move in relation to each other over a period of time. This information significantly impacts the decision-making process in the forex market.
Since currencies are traded in pairs, it is crucial for traders to comprehend the interrelationships between currency pairs. This understanding becomes especially important when traders engage in multiple pair trading simultaneously. By grasping the currency correlation, traders can gain a deeper understanding of how changes in one currency pair may influence other currency pairs, allowing them to make more informed trading decisions.
THE ROLE OF CURRENCY CORRELATION IN FOREX TRADING?
When utilizing currency correlation in forex trading, traders can gain valuable insights into positions that offset each other, allowing them to avoid such positions. Additionally, currency pair correlation can be used to diversify a trading portfolio. Further details regarding these strategies will be discussed below.
Currency correlation in the forex market is represented on a numerical scale using a "correlation coefficient." This coefficient ranges between -1 and +1, indicating the degree of correlation between two currencies. For instance, a correlation coefficient of +1 signifies a positive linear correlation, implying that the two currencies will always move in the same direction. On the other hand, a correlation coefficient of -1 indicates that the currency pair will always move in the opposite direction. When the correlation coefficient is 0, it signifies a random relationship between the currencies in the pair, indicating no correlation.
To illustrate, let's consider a positive correlation of 0.50 between the currency pairs AUD/USD and EUR/USD. This means that when AUD/USD experiences a rally, EUR/USD has also rallied 50% of the time based on past data. This correlation can be observed in the charts below.
The provided chart displays the currency correlation between EUR/USD (blue) and GBP/USD (red). The secondary chart in red shows the currency coefficient measure, which reveals that while the currency pair generally moves in a similar direction, there are instances of negative correlation. The peaks in the chart represent points where positive correlation is observed, while the troughs indicate periods of negative correlation.
In the second chart provided, it depicts the currency correlation between USD/CHF (gold) and EUR/USD (blue). The accompanying currency coefficient demonstrates that although the correlation between these currency pairs is predominantly negative, there are intermittent periods of positive correlation.
Currency correlation tables provide information on the correlation between major currency pairs and other pairs across various timeframes. However, it is important to note that these correlations are not fixed and can vary over time, as depicted in the aforementioned charts.
EUR/USD-GBP/USD CHART SGOWING THE CURRENCY COEFFICIENT
To illustrate, consider the given table that displays the correlation of GBP/USD with five significant currency pairs over 20 days, 60 days, and 90 days.
| GBP/USD | EUR/USD | USD/JPY | USD/CHF | USD/CAD | AUD/USD | NZD/USD |
|---|---|---|---|---|---|---|
| 20 days | -0.16 | 0.25 | 0.50 | -0.35 | -0.33 | -0.57 |
| 60 days | 0.77 | -0.29 | -0.58 | -0.67 | -0.12 | -0.46 |
| 90 days | 0.61 | 0.20 | -0.36 | -0.45 | -0.01 | -0.03 |
Taking GBP/USD and USD/CHF as an example, there is a positive correlation observed over a shorter timeframe of 20 days. However, when considering the overall relationship between these pairs, it is generally regarded as a negative correlation, similar to the relationship between USD/CHF and EUR/USD. One of the main reasons for this negative correlation is the nature of the Swiss franc (CHF) as a safe haven currency. During periods of economic turmoil and when equity markets experience declines, the CHF tends to appreciate significantly. This tendency may explain the negative figures associated with the correlation between these currency pairs.
HOW CURRENCY RELATIONSHIPS HELP TRADERS MAKE DECISIONS?
Currency correlation is commonly employed by traders for inter-market trading, hedging positions, and diversifying risk.
Inter-market trading
Inter-market trading involves identifying markets that exhibit close correlations with each other. This approach can be beneficial because if patterns are unclear in one market, clearer patterns from a correlated market can be utilized to assist traders in making trades in the first market.
The commodities market, in particular, offers valuable opportunities for correlation analysis. For instance, the currency pair USD/CAD and the price of oil are closely related. Since Canada is the largest exporter of oil to the United States, the currency pair is sensitive to fluctuations in oil prices. When the price of oil rises, the Canadian dollar (CAD) tends to strengthen against the US dollar (USD). Another example involves the correlation between the Australian Dollar (AUD) and gold. The price increase in gold has a positive impact on the AUD due to Australia's significant role as one of the leading gold producers globally.
By considering such inter-market correlations, traders can gain insights and leverage the relationships between different markets, allowing them to make more informed trading decisions.
Hedging a position
Hedging a position involves taking measures to offset potential losses or reduce exposure to a specific currency. Suppose you have a bullish outlook on the Australian Dollar (AUD) and plan to buy AUD/USD. To hedge your USD exposure, it might be prudent to simultaneously buy USD/CHF. This way, any adverse movements in the USD would be offset to some extent by gains in the USD/CHF trade.
A key advantage of using currency correlations for hedging is the ability to exploit different pip or point values. For instance, while the pip value for a particular currency pair might be $10 for a standard lot of 100,000 units, a negatively correlated pair could have a pip value of $9.20 for the same lot size. This discrepancy in pip values can be leveraged effectively to create a useful hedge.
Diversifying risk
Another benefit of utilizing currency correlation is diversifying risk. By simultaneously trading multiple currency pairs, such as GBP/NZD, USD/JPY, and EUR/JPY, traders can analyze the correlations among these markets. If the three pairs exhibit low or negative correlations, it allows for effective diversification of trades. This means that even if one trade incurs losses, the other trades may still perform well, reducing the overall risk exposure.
In summary, forex correlations can serve as a valuable tool for hedging positions by offsetting exposure to specific currencies and for diversifying risk by trading uncorrelated or negatively correlated currency pairs.
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