Forex Correlation Pairs
To survive and thrive as a currency trader, it is essential to understand the whole concept of forex correlation pairs. A forex correlation is considered a significant market dynamic to let the trader know how the trade market functions.
More than 72 various currency pairs are available in the market to trade on. Some of these 72 currency pairs move in a similar direction, and some might act opposite. In short, they are correlated with one another to some degree.
By studying the dynamics of forex correlation pairs, you can quickly identify the Intermarket moves and manage risk effectively.
What is currency correlation in forex?
A forex currency correlation is a negative and positive relationship between two different currency pairs. Conversely, a positive correlation occurs when two currency pairs are moving in the same direction.
If the two currency pairs are moving in opposing directions, it is known as a negative correlation.
Through correlations, a trader can have an opportunity with which they can acquire greater profits. In addition, it can often be used to hedge the forex positions and gain a high-risk exposure.
If you think that one currency pair might move against or alongside one another, you can open another position to maximise your profits. You can also open another position to hedge the current risk exposure if the volatility rises in the trade market.
But in case if your currency correlation forecasts are entirely wrong or if the market has started to move in an unpredictable path, then incurring a steeper loss comes in your way. Possible, the hedge will be less effective than you expected it to be.
Generally, the strength of your currency correlation is based on the time of day you are trading. The trading volume of both currency pairs also defines the strength of currency correlation.
For example, a currency pair of US dollars will be more active during the US market hours, i.e., 12 pm till 8 pm. And a currency pair based on a pound or Euro will be extra active from 8 am till 4 pm.
How does the correlation coefficient work?
FCA, FSCA, ASIC, SCB
Correlation coefficients range from -1 to 1, which shows a positive and negative currency correlation, respectively. But if the value is equal to 0, then it means that the currency pairs are not correlated.
- A correlation value of 1 will display both the currencies moving in the same direction, either bearish or bullish.
- A correlation value of -1 will display both the currencies moving in the opposite direction, either bearish or bullish.
- 0 correlation value appears when there is no such relation between two currencies.
In the forex, those currency pairs who have a common base or quote currency are generally correlated. Therefore, a trader should have extensive knowledge about which currency pairs correlate to acquire bigger profits.
How to trade on forex pair correlations?
A trader can start trading on forex pair correlations by simply identifying which currency pairs have negative and positive correlations.
In general, you have to open two positions if the currency correlation is positive. And you have to open two opposite positions if the currency correlation is negative.
If there is any negative correlation between AUD/USD and USD/CAD, having a long position over both the pairs will effectively cancel each other. This is because it is assumed that the pairs have now started to be in an opposing direction.
If the correlation on a currency is perfectly positive, then separate long positions on two different pairs can help to increase the trade profits. But, on the other hand, it might even increase the losses if the forecast is wrong.
You can even trade on the forex pair correlations for hedging the risk on active currency trades. For instance, you can take out a long position on the USD/CHF to hedge the losses you might incur over the long EUR/USD currency position.
Which are the most highly correlated currency pairs?
As we talk about highly correlated currency pairs, they are the ones having close economic ties.
For example, GBP/USD and EUR/USD are positively correlated due to their close relationship between the British pound and Euro.
In the below table, we have a few basic examples of correlations between the popularly traded currencies worldwide. The correlation between them was calculated in November 2019 by using the Pearson correlation coefficient:
What is the impact of currency correlations on Forex trading?
Plus, they can also illustrate the risk amount which is exposed within your trading account. For example, if you have purchased numerous currency pairs with a strong positive correlation, a high directional risk will come your way.
Hence, you can prevent all those positions which are effectively cancelling each other out. As a result, USD/CHF and EUR/USD have a stronger negative correlation.
If you are into directional bias, then buying both USD/CHF and EUR/CHF will eventually counteract the movements in each pair.
Understanding the whole concept of correlations allows you to diversify and hedge your exposure within the Forex market.
The best solution is to take your position in a negatively correlated pair to hedge a trade position.
Sometimes with a long buy for EUR/USD, it starts to move in an unfavourable direction. If it happens to you, you can hedge the trade position by buying a currency pair that negatively correlates with the currency EUR/USD, such as USD/CHF.
List of commodities correlated with currencies
The value of a few currencies is not just correlated with the value of some other currencies. It might be correlated with the price of a few commodities as well. This can be true if a particular country is the net exporter of any specific commodity, including gold or crude oil.
1. CAD & crude oil
The price of the Canadian dollar is positively correlated with the oil price. Therefore, a specific increase in oil price will gradually increase the price or value of the Canadian dollar. And this sudden increase in value will increase its importance in the forex market.
The USD/CAD currency pair movement often reflects this correlation because oil is generally traded in the US dollar. And we all know that the US dollar is negatively correlated with the oil price. If the value of the US dollar increases, the oil price will gradually reduce/decrease.
We can also say that an increase in oil price will decrease the value of the US dollar in the forex market. Therefore, traders should take a long trading position on the Canadian dollar with the pair CAD/JPY when oil value rises.
In the same way, a shorter position on the US dollar can be taken within the currency pair of USD/CAD.
2. AUD & gold
A gold price is many times positively correlated with the value of the Australian dollar. And this is very much seen in the currency pair of AUD/USD.
Australia is known to be the net exporter of gold. When the fold price rises, a sudden increase is also seen in the value of AUD/USD. In the same way, a decrease in the gold price will also reduce the value of currency pairs.
When the value of AUD/USD rises, you have to sell more US dollars to buy a single Australian dollar. This shows that the value of the Australian dollar is powerful as compared to the US dollar.
If we talk about the correlation between crude oil and the Canadian dollar, the value of gold and the Australian dollar are positively correlated. And in this state, the value of the US dollar is also negatively correlated to both.
The Australian dollar is also known as commodity currency because it has a value that is closely tied with the value of a few of Australia’s commodity exports. This includes gold, coal, copper, and agricultural products.
From all the exporters, as mentioned earlier, gold has the greatest positive correlation with the Australian dollar.
3. JPY & gold
The Yen is known to be the third-largest currency that is traded in the forex market. The value of this currency often moves in conjunction with the gold price.
It would not be wrong to say that currently, Yen is the world’s largest reserve currency against the Euro, US dollar, and British Pound.
Yen is the safe-haven currency, and gold is the most safe-haven asset in the trade market. Therefore, many traders move their invested money into gold or Yen during uncertain economic conditions or slow growth.
One unit of yen and one unit of gold have different prices, and different up and down movements will let the assets mirror one another.
According to some traders, this correlation between yen and gold value is due to the similarity of real interest rates for these two assets. Real interest rate is the rate of interest which a market participant will eventually receive after financing for inflation.
What is the primary purpose of the currency pair correlation indicator for MT4?
To perform an excellent currency correlation pair, an indicator for MT4 is used to analyse a trading asset’s statistical movement. It even helps you see how the currency pair moves either in the same or opposite directions.
Plus, currency pair correlation indicators often display to you the extent to which two currency pairs or assets have moved. This can be either in the same direction, opposite directions, or in a direction that is entirely random as compared to the previous one.
The Currency Pair Correlation Indicator was designed to help traders assess the average movement between two trading currency pairs or assets.
Can a currency correlation change in forex?
A trader needs to be prepared enough to encounter any change in currency correlation that can occur with time.
Few primary reasons behind these currency changes can be varied economic and political factors. This can be commodity prices, individual monetary policies, or changes in the policy of central banks.
It is essential to keep yourself updated with the latest currency relationships, which are constantly shifting. Therefore, look for the correlations which are long-term and should obtain a deeper perspective.
A currency correlation is undoubtedly a powerful tool for developing a solid forex pair correlation strategy with a high probability.
You can get guidance in risk management to keep track of correlation forex daily, weekly, monthly, or yearly.
Why do currency pairs have an inverse correlation?
When we talk about forex minors and majors, USD is the only currency paired with most currency pairs.
We all know that currency pairs also move in an utterly correlated way, making it possible for them to acquire a perfect negative correlation.
If any currency pair is moving in a perfect negative correlation, it is represented as 0. Once the currency pair starts to move upward, the negative correlation currency pair will move downward.
If the currency pair EUR/USD is moving downward, the USD’s strength is increasing. Traders are buying USD just because they believe in the prospect of the US economic future vs. the Euro.
But the question is when an inverse correlation occurs!
If USD rises, currency pairs with USD, which is at the front, such as USD/CAD, will rise equally. In this situation, traders are buying USD and are selling CAD.
As the market favours USD more, the chart of USD/CAD will move upward. It is because USD is the reverse currency.
Anything affecting the currency of USD will have a greater effect on different USDforex pair crosses.
Major forex trading strategies based on correlation
- If two currency pairs are highly correlated, then one of them can serve as the leading indicator of the price movement of the other one. If one correlated pair shows a sharp move, it will anticipate a probable move towards the other pair.
- Compared to the rest of the Forex indicators, correlation is a powerful tool that a trader can use to identify market or currency conjunction. For example, if one currency pair has broken itself below or above the technical level of resistance or support, a high probability is expected in a positively correlated pair.
- Price reversal is also expected to be seen in currency correlation. In this condition, a downward reversal is displayed in a negatively correlated pair and often encounters an upward price reversal in one currency pair.
- You have to wait for the abnormal divergence between the two highly correlated currency pairs. Then, buy one and sell the other pair just with an expectation that a price movement will appear again.
Significant reasons why traders use forex correlation pairs
Traders typically use currency correlation for inter-market trading, hedge a position, or diversifying risk. Let’s explain a bit about each one of them below:
1. Inter-market trading
It can be helpful for a trader to identify the markets which are closely correlated with one another. If you fail to show clear patterns in one market, a set of more apparent patterns can be adopted for the second market for better placement of trades. For example, the commodities market is highly useful for currency correlation.
One best example of inter-market trading is the oil and USD/CAD currency pair. Canada is known to be the biggest exporter of oil to the US. And therefore, the USD/CAD pair is susceptible to the commodity price.
Once the oil price starts to rise, CAD often tends to strengthen itself against the USD.
Another prominent example is the correlation of the Australian dollar AUD with gold. Once the gold price rises, a considerable rise in AUD is also noticed. Australia is known to be the leading producer of gold in the current market.
2. Hedging a position
Hedging a position is known to be a significant reason for trading forex correlations. Some traders are pretty bullish about AUD, and they want to invest in an AUD/USD pair. In that condition, buying USD/CHF will hedge some USD exposure which is a decent movie.
When hedging the exposure, a trader can use different points or pip values. A negatively correlated pair is formed once the pip value moves from $10 for a lot of 100,000 units.
3. Diversifying risk
The traders also use currency correlation for diversifying the risk. By trading on three currency pairs, you can run the analysis between three markets to see if they are correlated or not. This is how a trader can effectively diversify their trades.
How is hedging strategy helpful in forex correlation?
The Forex Correlation Hedging Strategy is considered to be an effective forex trading strategy. You can use this strategy with any currency pair.
Two different positions are formed, which are namely, long trading position and short trading position. They generally banned the short and long trading positions because they are not capable of being used with one currency pair.
In addition, this strategy is also effective for decreasing the risk of loss in trading. By overcoming the risks, the chances of gaining more profit can be earned.
Amid numerous currency pairs, the use of the Forex Correlation Hedging Strategy is quite common. This is because it reduces the chances of facing potential risks at any stage of trading.
Put option and call option are two primary options used in correlation trading having diverse functions and purposes.
When you are into trading, it is evident that if you are gaining some profits, then on the other side, you face losses as well. So if a system is giving you some advantages, then it has some disadvantages as well. The same is the case with Forex Correlation Hedging Strategy as well.
Sometimes a trader assumes that using two similar currency pairs in trading will correlate or match them to move in the same direction. This is an entirely wrong direction and a big NO!
Why is trading on forex correlation pairs so popular?
To start trading on correlation pairs, you should have extensive knowledge about which pairs have positive or negative correlations. This is essential to see how the trade works for you!
Sometimes a trader might lock itself in a position where they choose currency pairs that have a positive correlation. This is because a positive currency correlation pair always moves together in the same direction. But with a negative correlation, it is the opposite.
If there is some negative correlation between USD/CAD and AUD/USD, then definitely possessing a long position on both pairs will cancel each other. And eventually, the pair will start moving opposite to one another.
But if there is a positive correlation, you will experience a considerable profit within long positions.
You need to be careful during positive correlation because a single wrong forecast can increase your chances of facing a loss.
The traders need to have a solid hold on the positions of currency pairs that are correlated. In this way, traders can expand themselves by preserving the same currency movement, either downward or upward.
Note: It is pretty rare to get highly correlated currency pairs. Uncertainty will always come your way as a trader.
To sum up the whole discussion, it is evident that currency correlations can be either negative or positive. If it is a positive correlation, then both the currency pairs are moving in the same direction. But in negative correlations, two currency pairs generally move in an opposite direction.
Whether a correlation is negative or positive, it offers an opportunity to the traders to make significant profits and hedge a vast exposure. Currency can often be correlated with the export’s value of a commodity, including gold or oil.
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