How to Trade Correlated Forex Pairs
In this article
It’s a great idea to determine which currency pairs correlate and how you can benefit from the Forex market. The correlated Forex pairs list may help you learn more about how correlation functions. A currency correlation in Forex results from an exchange rate relationship between different currency pairs.
When two currency pairs move in tandem, there is a positive correlation. When there is an inverse correlation between two Forex pairs, they will move against each other. By taking advantage of correlations, you can gain adequate, which you can use to hedge your Forex positions and lower your risk.
When you are confident that one pair will go in tandem with another or opposite to another, you may choose to unlock another position to increase your profit.
Correlation in Forex trading
Currency correlations or Forex correlations are a way for SA traders to determine whether one Forex pair will move similarly to another. For example, if two currency pairs go up or down simultaneously, this is believed to be a positive correlation.
Alternatively, when one FX pair moves against another when one rises and the other falls, it is called a negative correlation. Therefore, the correlation between currencies should be monitored and understood when analysing any commodity, stock, or complex instruments, not just when analysing the price.
This article examines the relationship between Forex currency correlations and how it affects trades.
What is the correlation coefficient?
Correlation coefficients measure the strength or weakness of a correlation between two currencies. There is a range of coefficients between -1.0 and +1.0. It is rare to find exact coefficients between -1.0 and +1.0. For example, 0.8 or 0.7 are more common than coefficients between -1.0 and +1.0.
- FX pairs have a higher correlation (the extent to which their values are related) when a number is closer to 1.0. On the other hand, when the correlation coefficient is closer to 0.0, the relationship between currency pairs is weaker.
- A ‘+’ sign indicates a positive correlation means the same direction, while a ‘-‘ sign indicates a strong negative correlation (in the opposite direction).
Positive or negative correlation – which is considered strong?
Generally, FX pairs with a correlation coefficient below -0.7 and above +0.7 are considered to have strong correlations. Alternatively, a correlation between -0.7 and +0.7 indicates a weak correlation between the pairs. Correlation coefficients close to 0 indicate no discernible relationship between the FX pairs.
What do correlated Forex pairs mean?
The movement of FX pairs is correlated when they depend on one another. For example, FX pairs can be correlated when the currencies belong to the same economy or have the same base currency.
The EUR/USD and the GBP/USD pair have USD as a common factor. Further, the Eurozone and Great Britain are closely linked economies. The correlated currency pairs are due to these factors.
Most USD currency pairs move in the same direction whenever the USD is on the quote side of the exchange rate. So, for instance, you can also find AUD/USD and NZD/USD as positively correlated Forex pairs.
Some Forex pairs with a strong correlation tend to have a weaker relationship. In comparison, others will have a stronger relationship because each currency represents a separate economy and sells various goods and services, affecting the exchange rate differently!
What do non-correlated forex pairs mean?
Pairs of currencies that move independently of each other are considered non-correlated. Currency pairs can show this phenomenon when the currencies involved are different or when the economies of the currencies involved are different.
A close economic relationship exists between the Eurozone and Great Britain, which is reflected in the EUR/USD and GBP/USD, which both contain the US dollar. Thus, they tend to move together, though this is not always the case. In contrast, EUR/JPY and AUD/USD do not have matching currencies. Each Eurozone, Japan, Australia, and the United States has a distinct economy. As a result, there is a lower correlation between these pairs.
Highly correlated currency pairs
Which Forex pairs have the highest correlation? That is a question that a lot of people ask. FX pairs with strong economic ties almost always represent a close correlation.
Since the British Pound and the Euro are achieving a closer relationship, there is frequently a positive correlation between GBP/USD and EUR/USD. This is because they are geographically close or far and are the most-coveted and highly regarded reserve currencies worldwide.
Correlation tables between Forex pairs provide examples of correlations between highly traded currencies worldwide. FX pair correlations are shown below after a month’s correlation calculations. We used the Pearson correlation coefficient in this calculation.
Correlations do change
Correlations do change, which makes observing correlation shifts even more critical. Factors such as sentiment and global economics can frequently change. Today, a strong correlation between two currency pairs might not indicate the longer-term relationship between the two.
Thus, it is essential to examine the six-month trailing correlation. The relationship between the two currency pairs is shown in a six-month moving average, which is typically more accurate. The cause of changes in correlations can be attributed to diverging monetary policies, the sensitivity of certain currencies to commodity prices, or unique economic or political factors.
Calculating correlations yourself
By calculating your correlation pairings, you’ll be able to keep up with their direction and strength. In addition, the software allows you to calculate correlations for various inputs easily.
Use a spreadsheet program like Microsoft Excel to calculate a simple correlation. For example, you can download historical daily currency prices (even some free ones) from charting packages, which you can enter into Excel.
Using Excel, type =CORREL(range 1, 2) and see the correlation. The 1-year, 6-month, 3-month, and one-month trailing readings provide the most comprehensive view of changes in correlation over time. First, however, you decide how many or which of these readings you wish to analyse.
Here is a step-by-step overview of correlation calculation
For example, obtain the pricing data for the GBP/USD and the USD/JPY FX pairs.
- Label each of these pairs in two columns. Then, complete the columns with the past daily prices that occurred over the period you are analysing for each pair.
- At the bottom of one column, type =CORREL( into an empty slot.
- You should get a range in the formula box if you highlight all the data in one of the pricing columns.
- Enter a comma to indicate a new cell.
- Repeat steps 3-5 for the other currency.
- Closing the formula will look like =CORREL(A1:A50, B1:B50).
In this example, the correlation between the two positively correlated pairs is represented by a number.
The correlations will likely change over time, but you do not need to update your daily numbers. Generally, you should update at least once a month, if not more frequently.
How to use correlations to trade Forex?
Once you are familiar with calculating correlations, we can now discuss how to use them.
Firstly, ensure that you don’t enter the same position twice. If you knew that EUR/USD and USD/CHF move in opposite directions nearly 100% of the time, you would understand why holding long EUR/USD, and long USD/CHF is equivalent to holding virtually no position because the correlation indicates that when EUR/USD rallies, so will USD/CHF. A long position in EUR/USD and AUD/USD or NZD/USD is like doubling up on the same position because the correlation is significant.
Another critical factor is diversification. Since the EUR/USD and AUD/USD correlation is not always 100% positive, South African traders can use these two pairs to diversify their risk while maintaining a core directional approach. For example, to express a bearish outlook on the USD, the trader might buy one lot each of EUR/USD and AUD/USD instead of buying two lots of EUR/USD.
In contrast to the perfect correlation between the two different currency pairs, the imperfect correlation offers some diversification and a marginal reduction in risk. Further, Australia’s central bank has a different monetary policy outlook than Europe’s, so a dollar rally may affect the Australian dollar more than the euro or vice versa.
In addition to different pip and point values, traders can use them to their benefit. Look at the EUR/USD and USD/CHF once more.
The EUR/USD and USD/CHF have a nearly perfect negative correlation, but for many 100,000 units, the EUR/USD pip move represents $10, and the USD/CHF pip move represents $9.24. This suggests traders can hedge against EUR/USD exposure using USD/CHF.
Here’s how it would work:
Suppose a trader owned 100,000 USD/CHF and 100,000 EUR/USD short lots. An increase in EUR/USD by ten pips would result in a $100 loss for the trader. As the USD/CHF moves in the opposite direction of the EUR/USD, a short USD/CHF position would likely increase to ten pips to $92.40.
In this scenario, the portfolio would lose -$7.60 rather than -$100. Of course, this hedge also means lower profits in case of a substantial EUR/USD decline, but losses should be relatively lower in a worst-case scenario.
It is imperative to be aware of the correlation between FX pairs and their shifting trends, regardless of whether you want to diversify your positions or find alternate pairs to leverage your view. This knowledge is powerful for all professional South African traders who hold multiple FX pairs on their retail investor accounts. Diversifying, hedging, and even doubling profits can be accomplished with this information.
Change of currency correlation in Forex
Currency correlations constantly change over time, and the trader’s awareness is necessary. Several political and economic factors have contributed to these changes. Factors such as separate monetary policies, price changes, and changes in central bank policies are usually involved in the Forex market.
Currency exchange rates are constantly changing, so it is vital to stay updated. The picture becomes more apparent if we check for long-term correlations. The correlations between FX pairs can be a highly effective tool for developing a Forex pair correlation strategy with a high probability.
By tracking the correlation coefficient daily, weekly, monthly, or annual, you can make informed decisions in risk management.
What are some examples of currency correlation?
Currency correlation hedging purposes
The concept of correlation allows traders to hedge positions by taking a second trade that moves against the first position. A currency hedge offsets gains from one pair of currencies with losses from another. When the pair pulls back, traders can use this to reduce or offset their loss when they do not want to exit a position.
For example, there is a strong positive correlation of 75 between EUR/USD and AUD/USD. A partial hedge can be created by purchasing EUR/USD and selling AUD/USD. Because the correlation is only 75, it doesn’t consider the magnitudes of price movements, only directions.
A negative correlation exists between the GBP/USD and the EUR/GBP. By buying and selling both, you create a hedge. If the GBP/USD rises, buying it will make money, but losses on EUR/GBP will be offset by gains on GBP/USD since the correlation is negative.
Pairs Forex trading
Pairs trades involve taking long and short positions on two currency pairs with a strong historical correlation, such as 80 or higher. Traders can buy currency pairs that are moving down, and traders can sell currency pairs that are moving up. They are expected to eventually move together again based on their long history of high correlation. It is possible to realise a profit if this happens.
Although, there is a high risk that the pairs won’t resume being highly correlated. Using stop-loss orders can control the loss of a position for some traders. Even if the pairs move back toward their previous correlation, there is also the possibility that a loss on one trade won’t be offset by a gain on the other, resulting in a loss. If the bought and sold positions move up and down as the pairs mean-revert, both positions would be profitable.
Risk management is one of the most important components of any currency correlation strategy. A small percentage of the account is risked if the stop loss is reached, depending on where the stop loss is placed. A micro lot trade at a 30 pip stop loss in the EUR/USD (with a USD account) entails a risk of $3 (30 times $0.10). To ensure the trader’s risk is no more than 1% of the account, he would need to have at least $300 on hand.
In addition to currencies, commodities or raw materials correlate with one another. There was little correlation between gold (XAU/USD) and other major currencies. Nevertheless, it indicates a positive correlation with silver (XAG/USD). It is important to carry out this analysis if you trade gold and have positions in other currency pairs.
There is no high correlation between natural gas and any currency pair or precious metal, such as gold or silver. Additionally, crude oil (WTICO) isn’t highly correlated with currencies, although it does show some correlation with the USD/CAD and CAD/JPY. This is because both Canada and Japan import a lot of oil.
When there is a strong correlation between currencies and commodities, commodities can be hedged or hedged by currencies. A commodity can move in percentage terms much more than a currency, so gains or losses in the other may not fully offset gains or losses in one.
From the information above, you know that AUD/USD and NZD/USD are positively correlated. You will see almost identical price charts if you compare their charts. You can predict with a high degree of certainty the future movement of one by looking at its twin when it is lagging.
Be cautious when opening orders with correlated pairs, as it can increase your risk level. For example, the AUD/USD and NZD/USD pairs positively correlated. You will double your profit if your forecast is accurate. It is also possible to double the loss if the price does not follow your expectations. If a trader is exposed to such a risk, how can they minimise it? Signals from correlated pairs can be very useful!
Consider the EUR/USD pair, for instance, before opening a long order. Instead, you should analyse the correlated pair (GBP/USD) to confirm your trading signals. When GBP/USD or another positively correlated pair gives a bullish signal, you can only be more confident about going long on EUR/USD!
Should you trade correlated Forex pairs?
When two currency pairs move in tandem, they have a positive correlation; when they move in the opposite direction, they are said to have a negative correlation. So using correlations to realise a more significant profit or hedge your Forex exposure is one way to benefit from them.
How do you read currency correlations?
When a correlation is +1, both currency pairs will move in the same direction 100% of the time. In case of a correlation of -1, the two currency pairs will move in the opposite direction every time. The zero correlation indicates a completely random relationship between the currency pairs.
How do currency pairs work in Forex?
A Forex broker offers currency pairs where you buy the base currency and sell the quote currency. As a result, you receive the quote currency when selling a currency pair. Pairs of currencies are quoted using bid (buy) and ask (sell) prices.
What are the most correlated FX pairs?
Over time, correlations change, as stated in the article. Certain tendencies, however, remain the same. Exchange rates that tend to move together (i.e., with a strong positive correlation) tend to be:
EUR/USD – GBP/USD – AUD/USD – NZD/USD
USDCHF – USDJPY
Rather, FX pairs that move in opposite directions (i.e., have a negative correlation) are generally:
EUR/USD – USD/CHF
GBP/USD – USD/JPY
USD/CAD – AUD/USD
What are the most stable currency pairs?
Significant currencies with the least volatility are EUR/USD, GBP/USD, USD/JPY, USD/CHF, AUD/USD, GBP/JPY, EUR/JPY, and USD/CAD.
Currencies can have positive or negative correlations. Correlations, positive or negative correlations, provide an opportunity to benefit from a more significant profit or hedge the exposure. Currency values can also be linked to the value or utility of commodities like gold and oil exports.
This Forex pair correlation calculator allows the user to enter a currency pair, a time frame, and several periods to calculate the correlation among significant and exotic currency pairs over multiple time frames.
This suggests that you can use correlations between currency pairs as confirmation bias before entering a trade if you know how currency pairs correlate.
Not only that, but you can also use it to confirm the trend. For instance, if the USD strengthens, all positively correlated Forex pairs should fall, and negatively correlated Forex pairs should rise. The best place to find trading opportunities near supply and demand zones is to combine Forex pairs that correlate with candlestick patterns.
Jason Morgan is an experienced forex analyst and writer with a deep understanding of the financial markets. With over 13+ years of industry experience, he has honed his skills in analyzing and forecasting currency movements, providing valuable insights to traders and investors.
Forex Content Writer | Market Analyst