Have you ever noticed that when a certain currency pair rises, another currency pair falls? Somehow, they’re all connected.
Have you ever noticed that when a certain currency pair rises, another currency pair falls?
Or how about when that same currency pair falls, another currency pair seems to copy it and falls also?
If the answer is “yes,” you’ve just witnessed currency correlation in action!
If you answered “no,” you need to stop doing less important things like sleeping, eating, playing Super Mario Run or Pokemon GO, and instead spend more time watching charts. But no worries because we’re going to start with the basics and break it down yo…
The first half… easy. Currency. No explanation needed.
The second half. Still easy. Correlation: a relationship between two things.
In the financial world, correlation is a statistical measure of how two securities move in relation to each other.
Currency correlation, then, tells us whether two currency pairs move in the same, opposite, or totally random direction, over some period of time.
When trading currencies, it’s important to remember that since currencies are traded in pairs, that no single currency pair is ever totally isolated. (Did we just confuse you with our “currencies” tongue-twister sentence there?)
Unless you plan on trading just one pair at a time, it’s crucial that you understand how different currency pairs move in relation to each other. ESPECIALLY if you’re not familiar with how currency correlations can affect the amount of risk you’re exposing your trading account to.
If you don’t know what the heck you’re doing when trading multiple pairs simultaneously in your trading account, you can get KILLED!
Murdefied! Destroyed! We can’t stress this enough.
Do NOT be ignorant about correlations.
Correlation is computed into what is known as the correlation coefficient, which ranges between -1 and +1.
Perfect positive correlation (a correlation coefficient of +1) implies that the two currency pairs will move in the same direction 100% of the time.
Perfect negative correlation (a correlation coefficient of -1) means that the two currency pairs will move in the opposite direction 100% of the time.
If the correlation is 0, the movements between two currency pairs are said to have uh ZERO or NO correlation, they are completely independent and random from each other. We have no idea how one pair will move in relation to the other.
In this lesson, you’ll learn what currency correlation is and how you can use it to help you become a smarter trader and make more responsible risk management decisions.
Are you a visual learner? Do you like looking at sexy women or hunky men? If so, perfect!
Take a look at the following tables.
Each table shows the relationship between each main currency pair (in orange) and other currency pairs (in white) over various time frames. Remember, currency correlation is presented in decimal format by a correlation coefficient, simply a number between -1.00 and +1.00.
A coefficient near or at +1 indicates that the two pairs have strong positive correlation and will likely move in the same direction.
In the same respect, a coefficient near or at -1 indicates that the two pairs still have a strong correlation, but a negative one, resulting in the pairs moving in opposite directions.
A coefficient near or at zero indicates a very weak or random relationship.
When you are simultaneously trading multiple currency pairs in your trading account, always make sure you’re aware of your RISK EXPOSURE.
You might believe that you’re spreading or diversifying your risk by trading in different pairs, but many pairs tend to move in the same direction.
Let’s look at an example involving two highly correlated pairs within a one week period: the EUR/USD and GBP/USD.
Based on the table, with a sexy correlation coefficient of 0.94, there’s obviously a high correlation in this particular pair. EUR/USD is peanut butter to GBP/USD’s jelly! Like oil and water. Like Ben & Jerry’s!
Okay, you get the picture. The point is that the two pairs hold hands, sing “Kum Bay Yah”, and skip together.
To prove to you that the numbers don’t lie, here are their 4-hour charts. Notice how they both moved in the same direction…down.
Returning to the subject of risk, we can see that opening a position in both the EUR/USD and the GBP/USD is the same as doubling up on a position. For example, if you bought 1 lot of EUR/USD and bought 1 lot of GBP/USD, you’re basically buying 2 lots of EUR/USD, because both the EUR/USD and GBP/USD would move in the same direction anyway.
In other words, you are INCREASING your risk. If you buy EUR/USD and GBP/USD, you don’t get two chances to be wrong!
All you get it is one chance because if EUR/USD falls and you get stopped out, GBP/USD will most likely fall and stop you out also (or vice versa).
You also wouldn’t want to buy EUR/USD and sell GBP/USD at the same time because if EUR/USD skyrockets, then GBP/USD would probably skyrocket also and where does this leave you?
If you think your profit or loss will always be zero, then you’re wrong. EUR/USD and GBP/USD have different pip values and just because they are highly correlated doesn’t mean they always move in the same exact pip range.
Volatility within currency pairs is fickle. EUR/USD can skyrocket 200 pips, while GBP/USD only goes up 190 pips. If this happens, the losses from your GBP/USD trade (because you were short), will eat up most, if not all, of the gains from your EUR/USD trade.
Now let’s imagine that EUR/USD was the pair that moved up 190 pips, and GBP/USD had the bigger move of 200 pips. You would’ve definitely had a LOSS!
Going long one currency pair and going short another currency pair that are highly correlated is extremely counterproductive.
More than paying for the spread twice, you minimize your gain because one pair eats into the other pair’s profits.
And even worse, you could end up losing due to the different pip values and ever-changing volatility of currency pairs.
Let’s take a look at another example. This time with the EUR/USD and USD/CHF.
While we just saw a strong positive correlation with the GBP/USD, the EUR/USD has a very negative correlation with the USD/CHF.
If we look at its one-week correlation, it has a perfect correlation coefficient of -1.00. It doesn’t get any more opposite than this folks! Instead of Ben & Jerry’s, they’re Tom and Jerry!
EUR/USD and USD/CHF are like fire and water, Bugs Bunny and Elmer Fudd. Superman and kryptonite, Boston Celtics and Los Angeles Lakers, Manchester United and Liverpool.
These two pairs totally move in the opposite directions. Check out the charts:
Taking opposite positions on the two negatively correlated pairs would be similar to taking the same position on two highly positive correlated pairs.
Buying EUR/USD and selling USD/CHF would be the same as doubling up on a position.
For example, if you bought 1 lot of EUR/USD and sold 1 lot of USD/CHF, you’re basically buying 2 lots of EUR/USD, because if EUR/USD goes up, then USD/CHF goes down, and you’d be making money on both pairs. It’s important to recognize though that you have INCREASED your risk exposure in your trading account if you do this.
Returning to the example with you being long EUR/USD and short USD/CHF, if EUR/USD actually dropped like a rock, most likely both of your trades would be stopped out resulting in two losses.
You could’ve minimized your loss by simply deciding to go long EUR/USD OR go short USD/CHF, instead doing both.
On the other hand, buying (or selling) both EUR/USD and USD/CHF at the same time is usually counterproductive since you’re basically cancelling each trade out.
Because the two pairs move in opposite directions like they hate each other’s guts, one side will make money, but the other will lose money.
So you either end up with little gain because one pair eats into the other pair’s profits.
Or you could simply end up with a loss due to each pair’s different pip values and volatility ranges.
Currency correlation tells us whether two currency pairs move in the same, opposite, or totally random direction, over some period of time.
When trading currencies, it’s important to remember that since currencies are traded in pairs, that no single currency pair is ever totally isolated. Correlation is computed into what is known as the correlation coefficient, which ranges between -1 and +1.
Here is a guide for interpreting the different currency correlation coefficient values.
|-1.0||Perfect inverse correlation|
|-0.8||Very strong inverse correlation|
|-0.6||Strong, high inverse correlation|
|-0.4||Moderate inverse correlation|
|-0.2||Weak, low inverse correlation|
|No correlation. Totally random.|
|0.2||Very weak, insignificant correlation|
|0.4||Weak, low correlation|
|0.8||Strong, high correlation|
So now you know what currency correlation is and how to read it off a fancy chart. But we bet you’re wondering how using currency correlations will make your trading more successful?
Why do you need this wondrous skill in your trader’s tool bag?
There are several reasons:
Utilizing correlations can help you stay out of positions that will cancel each other out. As the previous lesson shown, we know that EUR/USD and USD/CHF move in the opposite direction almost 100%.
Opening a position long EUR/USD AND long USD/CHF is, then, pointless and sometimes expensive. In addition to paying for the spread twice, any movement in the price would take one pair up and the other down.
We want our hard work to pay off with something!
Leverage profits….or losses! You have the opportunity to double-up on positions to maximize profits. Again, let’s take at look at the 1-week EUR/USD and GBP/USD relationship from the example in the previous lesson.
These two pairs have a strong positive correlation with GBP/USD following behind EUR/USD virtually step for step.
Opening a long position for each pair would, in effect, be like taking EUR/USD and doubling your position.
You’d basically be making use of leverage! Mucho profit if all goes right and mucho losses if things go wrong!
Understanding that correlations exist also allows you to use different currency pairs, but still leverage your point of view.
Rather than trading a single currency pair all the time, you can spread your risk across two pairs that move the same way.
Pick pairs that have a strong to very strong correlation (around 0.7). For example, EUR/USD and GBP/USD tend to move together. The imperfect correlation between these two currency pairs gives you the opportunity to diversify which helps reduce your risk. Let’s say you’re bullish on USD.
Instead of opening two short positions of EUR/USD, you could short one EUR/USD and short one GBP/USD which would shield you from some risk and diversify your overall position.
In the event that the U.S. dollar sells off, the euro might be affected to a lesser extent than the pound.
Although hedging can result in realizing smaller profits, it can also help to minimize losses.
If you open a long EUR/USD position and it starts to go against you, open a small long position in a pair that moves opposite EUR/USD, such as USD/CHF.
Major losses averted!
You can take advantage of the different pip values for each currency pair.
For example, while EUR/USD and USD/CHF have an almost perfect -1.0 inverse correlation, their pip values are different.
Assuming you trade a 10,000 mini lot, one pip for EUR/USD equals $1 and one pip for USD/CHF equals $0.93.
If you buy one mini lot EUR/USD, you can HEDGE your trade by buying one mini lot of USD/CHF. If EUR/USD falls 10 pips, you would be down $10. But your USD/CHF trade would be up $9.30.
Instead of being down $10, now you’re only down $0.70!
Even though hedging sounds like the greatest thing since sliced bread, it does have some disadvantages.
If EUR/USD rallies, your profit is limited because of the losses from your USD/CHF position.
Also, the correlation can weaken at any time. Imagine if EUR/USD falls 10 pips, and USD/CHF only goes up 5 pips, stays flat, or falls also!
Your account will be bleeding more red than the Red Wedding in Game of Thrones.
So be careful when hedging!
You can use currency correlations to confirm your trade entry or exit signals.
For example, the EUR/USD appears to be testing a significant support level. You observe the price action and are looking to sell on a breakout to the downside.
Since you know EUR/USD is positively correlated with GBP/USD and negatively correlated with USD/CHF and USD/JPY, you check to see if the other three pairs are moving in the same magnitude as EUR/USD.
You notice that GBP/USD is also trading near a significant support level and both the USD/CHF and USD/JPY are trading near key resistance levels.
This tells you that the recent move is U.S. dollar-related and confirms a possible breakout for EUR/USD since the other three pairs are moving similarly. So you decide you will trade the breakout when it occurs.
Now let’s assume the other three pairs are NOT moving in the magnitude as EUR/USD. The GBP/USD is holding not falling, USD/JPY is not rising, and USD/CHF is sideways.
This is usually a strong sign that the EUR/USD decline is not U.S. dollar-related and most likely driven by some kind of negative EU news.
Price may actually trade below the key support level you’ve been monitoring but because the other three correlated pairs aren’t moving in proportion with EUR/USD, there will be lack of any price follow-through and price will return back above the support level resulting in a fakeout.
If you still wanted to trade this setup, since you didn’t get any “correlation confirmation” from the other pairs, you could play it smart by reducing your risk and trading with a smaller position size.
The forex market is a like a schizophrenic patient suffering from bipolar disorder who constantly eats chocolates, experiences extreme sugar highs, and has volatile mood swings all day long.
We’re not even exaggerating. Although currency correlations between currency pairs can be strong or weak for days, weeks, months, or even years, they do eventually change and can change when you least expect it.
The strong currency correlations you see this month may be totally different next month. Have a look at the table below.
Compare the coefficients for a given pair across the different time frames.
Do you notice anything?
For the most part (thanks, USD/JPY!), they’re different across the board, changing from one time frame to another. And they change in all directions.
The lesson here is that currency correlations do change, and they change frequently.
And they can change by a drastic measure in a short time frame, as is apparent by looking at EUR/USD at the 1 Month and 3 Month interval.
That’s a big swing!
Because of the constant sentiment shifts of the currency market, make sure you’re aware of the current currency correlations.
For example, over a one week period, the correlation between USD/JPY and USD/CHF was 0.22. This is a very low correlation coefficient and would indicate that the pairs have an insignificant correlation.
However, if we look at the three-month data for the same time period, the number increases to 0.52 and then to 0.78 for six months and finally to 0.74 for a year.
In this example, you can see that these two pairs had a “break-up” in their long-term correlation relationship. What was once a strongly positive association in the the past has extremely weakened in the short-term. If they were a real couple and had only dated a month or less, they would’ve thought they were incompatible.
Little do they know, the passion will start heating up later!
If you look at EUR/USD and GBP/USD, here’s an example of the extent to which currency correlations can change and jump around.
The one-week period shows a very strong correlation with a 0.94 coefficient!
…But this relationship severely deteriorates in the one-month period, dropping to 0.13, before improving again for its three-month period to a solid 0.83, then deteriorating again to a weak correlation in its six-month trailing period.
Here’s a crazy example on how dramatic currency correlations can change.
Let’s take a look at USD/JPY and NZD/USD…
Their one year correlation coefficient was -0.69.
This indicates a moderate to strong correlation.
But if you look at their one month correlation, the correlation coefficient essentially flip flopped!
So be careful.
Currency correlations change for many different reasons.
These can include anything from a country changing interest rates, to shifting monetary policies, or any collection of economic or political events reshaping traders’ sentiment on a currency.
As you’ve read, correlations will shift and change over time. So keeping on top of current coefficient strengths and direction becomes even more important.
Lucky for you, currency correlations can be calculated in the comfort of your own home, just you and your most favorite spreadsheet application.
For our explanation, we’re using Microsoft Excel, but any software that utilizes a correlation formula will work.
Step 1: We’re assuming that you won’t be magically creating the daily price data out of thin air, but rather, will be getting it somewhere online. One source is from the Federal Reserve.
Step 2: Open Excel.
Step 3: Copy and paste your data into an empty spreadsheet or open the exported data file from Step 1. Get the last 6 months!
Step 4: Now arrange your data to look like the following or something similar. Colors and fonts are up to you! Have fun with this. Yellow might not be the best option though!
Step 5: It’s time to decide on a time frame. Do you want last week’s currency correlation? Last month? Last year?
The amount of price data you have will dictate this, but you can always get more data. For this example, we’re using the last month.
Step 6: In the first empty cell below your first comparison pair (I’m correlating EUR/USD to the other pairs, so I’m starting with EUR/USD and USD/JPY), type: =correl(
Step 7: Next, select the range of cells for EUR/USD’s price data, followed by a comma. You’ll be surrounding this range with a box.
Step 8: After the comma, select USD/JPY’s price data range just like you did for EUR/USD.
Step 9: Click the Enter key on your keyboard to calculate the correlation coefficient for EUR/USD and USD/JPY.
Step 10: Repeat Steps 5-9 for the other pairs and for other time frames.
When you’re done, you can take your new data and create a cool looking table just like this. Man, that’s pro-status!
The one-week, one-month, three-month, six-month, and one-year trailing periods provides the most complete view of the correlations between currency pairs. But it’s up to you to decide which or how many time periods you want wish to analyze.
While it might be overkill to update your numbers every single day, unless you’re a currency correlation addict, updating them at least every other week should be enough.
If you find yourself manually updating your currency correlation tables every hour on Excel, you might need to get out more and pick up a hobby.
Like synchronized swimmers, some currency pairs move in tandem with each other.
And like magnets of the same poles that touch, other currency pairs move in opposite directions.
When you are simultaneously trading multiple currency pairs in your trading account, the most important thing is to make sure you’re aware of your RISK EXPOSURE
You might believe that you’re spreading or diversifying your risk by trading in different pairs, but you should know that many of them tend to move in the same direction. By trading pairs that are highly correlated, you are just magnifying your risk!
Correlations between pairs can be strong or weak and last for weeks, months, or even years. But always know that they can change on dime. Staying up-to-date with currency correlations can help you make better decisions if you want to leverage, hedge or diversify your trades.
Coefficients are calculated using daily closing prices.
Positive coefficients indicate that the two currency pairs are positively correlated, meaning they generally move in the same direction.
Negative coefficients indicate that the two currency pairs are negatively correlated, meaning they generally move in the opposite directions.
Correlation coefficient values near or at +1 or -1 mean the two currency pairs are highly related.
Correlations can be used to hedge, diversity, leverage up positions, and keep you out of positions that might cancel each other out.
When you find yourself wanting to trade two pairs that are highly correlated, it’s okay if you take both setups.
Just make sure you have rules in place when you traded correlated pairs and always stick to your risk management rules!
This post was last modified on March 3, 2019 1:10 pm