Have you heard of currency correlations? It’s something all Forex traders need to be aware – as some currencies are actually linked in price. This is especially important if you intend to trade multiple positions at the same time. But what are currency correlations? In this article, I explain them in detail.
Positive & negative correlations
Have you ever noticed how certain currency pairs follow each other on a price chart? If you pay close attention, you might have noticed that other currency pairs tend to move in the opposite direction. This phenomenon is known as currency correlation.
There are two types of currency correlation. Positive currency correlation is where two pairs tend to move in the same direction. Conversely, negative correlation is where two pairs tend to move in opposite direction. However, it’s important to note that not all currency pairs have a correlation – their relationships are simply random.
But currency correlations aren’t static. In fact, the correlation between currency pairs can actually change over time. So it’s important that you keep track of how correlations between pairs change.
Why do correlations exist?
Before I outline how to track currency correlations, let’s explore why they exist. The answer is more simple than you might think.
Links exist because we trade currencies in pairs. For example, if USD is getting sold off, then all pairs with USD in it will most likely start moving in line with the weaker USD.
Fundamental links also exist between currencies. A classic positive correlation is between the euro and Swiss franc. This occurs because of the extremely close economic ties between the eurozone and Switzerland. As such, if the euro falls, it’s likely the Swiss franc will too. This is because traders fear that any negativity from Europe will spill over and affect Switzerland.
Sometimes it can seem like there is a correlation between assets – but it’s not always the case.
For example, many people think there is a positive correlation between the Japanese yen and Gold. This is not the case. Rather, it is a symptom of market panic playing out in two different assets. Both JPY and Gold are safe haven assets. When the markets are volatile, investors and traders tend to shift their capital to these assets.
Why do currency correlations matter?
Hopefully, you now recognise that currency correlations can have a dramatic impact on your profitability.
Consider this scenario. You have two positions open simultaneously on different currency pairs. Both of these positions are ‘long’. But it just so happens these pairs are negatively correlated. Remember, this means they tend move in opposite directions to each other.
The result of this scenario is unnecessary losses. If you take the same position on two negatively correlated pairs, the trades can effectively cancel each other out.
A better strategy is to ensure that all your current open positions have a positive correlation. However, I don’t recommend this being your sole method of determining what trades to take. Instead, use fundamental analysis as your primary method.
How to identify currency correlations
So, how does a trader identify currency correlations? It’s actually very easy. You just need to find the correlation coefficient.
A correlation coefficient is simply a numerical representation of the link between two pairs. Typically, the numbers are between -1 and +1. Coefficients can also be represented as percentages, ranging from -100% to +100%.
- -1 or -100% represents a 100% negative correlation between two pairs.
- +1 or +100% represents a 100% positive correlation between two pairs.
- 0 or 0% represents no correlation between two pairs.
Coefficients that fall in between these ranges represent specific percentages. Here’s a simple example: – +0.7 (or +70%) indicates that two pairs move in the same direction 70% of the time.
You can easily view real-time coefficients between all currency pairs on free online tables. Clearly, you shouldn’t take the same position on currency pairs that have a coefficient of -1 (-100%).
Furthermore, coefficients can actually change depending on the timeframe. Again, you can view these on free online tables. One table I recommend comes from Myfxbook. It’s extremely detailed and easy to navigate.
Most brokers also provide free widgets or tools that display real-time currency coefficients. It’s vital that you keep track of how coefficients change – as it can impact your trading.
Putting coefficients into practice
Competent traders do everything they can to protect their capital. Checking currency correlations is one way to do this. It’s an integral part of risk management. If this is the first time you’ve come across currency correlation, you can follow these steps:
- Bookmark the currency correlation table on Myfxbook.
- Make a note of the currency pairs you plan to trade at the same time.
- Open the currency correlation table and check the coefficient of your chosen pairs across the relevant timeframe.
- Change your trading intentions if your pairs are negatively correlated.
What are currency correlations?
In summary, currency correlations are simply links between currency pairs. Some pairs move in the same direction, while others move in the opposite direction. Traders must be aware of these links, as it can affect their profitability if they have multiple open positions. This is typically done by viewing correlation coefficients on free online tables, which update in real-time.
I hope you have found this article useful. If you have any questions, please leave them in the comments below. I’ll try to answer as many as I can.