September 07, 2017
A correlation is a statistical term that measures to which extent two variables move in the same direction, opposite direction, or completely random in relation to each other.
A correlation of 1.00 means the two variables move in perfect correlation relative to each other, while a correlation of -1.00 means that the two variables move in completely different directions (i.e. if one going up $1, the other will move down $1). A correlation of 0.00 shows that there is no correlation between the two variables, i.e. they move in completely random fashion relative to each other.
When applied to the forex market, this means that two currencies can move in the same direction, opposite direction, or completely random relative to each other.
Knowing the currency correlations is very important to reduce risks, as your risk will be doubled when trading currencies with a high correlation coefficient.
The next table shows the correlation coefficients of EUR/USD to other major currency pairs, over a period of 1 week, 1 month, 3 months, 6 months and 1 year.
Make Sure not to Double Your Risk!
When trading two or more currency pairs at the same time, you need to know their correlation in order to avoid adding to your risk. Take a look at the table above, EUR/USD and AUD/USD have a very high correlation of 0.90 over one month, which basically means that when EUR/USD is moving up, so does AUD/USD. And when EUR/USD is moving down, so does AUD/USD.
Simply said, you double your risk by opening trades on EUR/USD and AUD/USD in the same direction.
On the other hand, you also don’t want to open trades at the same time on two pairs that are highly negative correlated, such as EUR/USD and USD/CHF, as they will basically cancel each other out, i.e. one trade may be a winner, but the other has a high change to be a loser.
Currency correlations change over time!
It’s also important to note that currency correlations will change over time. Do you see how the correlations change in the table above, over the different time frames? In fact, currency correlations change quite a lot and are never the same over the time. There are many factors that influence this, such as investor sentiment on a particular country, or interest rate changes by central banks.
You need to stay up-to-date on the most recent currency correlation coefficients, and many online sites will offer the newest correlation tables. Just do a quick Google search and you will find them.
Currency correlations are important as they can double your risk if your trades are positively correlated (and opened in the same direction), or leave you break-even if the trades are negatively correlated. That’s why it’s important to know the current correlation coefficients, and how to trade them to go in your favor. They can also double your profits if your analysis goes right, but you need to always make sure you trade in the boundaries of your risk management rules!