"Currency correlations are an important but often overlooked aspect when it comes to trading multiple currency pairs at the same time. Many traders do not pay attention to currency correlations because they fear that they will be missing out on trading opportunities. In fact, currency correlations are simple to understand. And by applying some logic you will be able to tell whether the currency pairs that you are trading have some kind of relationship or not. This will help you to manage your risk and at the same time, allows you to make a bigger profit by just simply understanding the correlations between the different currency pairs. In summary to the previous sections about currency correlations, this article gives you details into how you can use currency correlations to your benefit. We present five simple things that you need to look at in order to manage your risk and also to ensure that you are trading in the right direction."
Currency correlations are often overlooked when it comes to trading. Traders usually focus on their trading systems and perhaps on the risk management side of things. But very rarely does a forex trader look at the bigger picture.
This is partly because traders thinking that all it takes to make money in forex trading is by applying a trading system that they found off a forum or purchased and expect that it will make money for them.
The truth is rather different however. Among the many things, currency correlation is something that is very important. It is important for the sheer fact that it can tell you what currency pairs to avoid and what currency pairs to trade.
If you just look at trading in isolation without applying the concepts of currency correlations, you are trading the currency pair in isolation. As you already know by now, in forex trading, you never make a trading decision based on just variable.
For example, if you think that price will reverse simply because of a bearish candlestick pattern, your odds of success is just 50%. You will need to apply other concepts as well to validate whether this is a correct trading signal or not.
This comes due to the fact that the markets are irrational. While you do see a lot of coverage on the reversal candlestick patterns, it is the context that matters. Similarly, currency correlations can help you build context.
The question you should be asking yourself when you are trading two or more currency pairs is the underlying relationship between them.
In the previous articles, we covered in detail what currency correlation is all about and why it matters. In this article, we summarize all the things we learned into the top five factors you should consider when trading from a currency correlation point of view.
Firstly, there is a good chance that the two currency pairs you picked to trade are not correlated in anyway. For example, trading the AUD/NZD and the EUR/USD currency pair is one way to illustrate this. As you can see, the AUD/NZD is in no way correlated to the EUR/USD currency pair. But given the number of currency pairs there are, you might stumble upon currency pairs where there is some kind of correlation. This is what you should be paying attention to.
2. Positive and negative correlations
Then comes the set of currency pairs that have some kind of correlations. For example, in one of the previous articles, we covered the aspect of the XAU/USD and the GBP/JPY currency pairs.
Here, we notice that these two assets are strongly correlated inversely. Thus, knowing this information beforehand will prevent you from taking the same direction trade on the said currency pairs. Understanding whether two currency pairs have a correlation can play an important role in reducing your risk.
3. Correlation time frame
Correlations can change depending on the time frame that you are looking at. Typically, the accepted rule is that you look at a 30-day correlation from a daily time frame perspective.
If you look at correlations for shorter time frames, chances are that you will see these correlations to change quite dramatically. Thus, once you nail down the currency correlations it can help.
There is also a logical aspect to this. For example, if the USD is weak, and the EURUSD is rising, chances are that other currency pairs with a USD quote currency will also be rising.
4. Correlation coefficients
Correlation coefficients are important. It tells you the level of correlation two currency pairs enjoy. Typically, currency coefficients of 90% or higher give you the best odds of increasing your profits.
But there are also correlations that are much less. What this tells you is that while there is a correlation between two currency pairs, the level of correlation is lower. This means that some currency pairs can lag on their expected behavior compared to those which have a higher correlation coefficient.
It would be easy if currency correlations were just about looking at the coefficient values. Volatility also plays a big role. Volatility comes when you dig deeper to the reasons behind the behavior. You might have two currency pairs with a higher level of correlation. But the volatility is what dictates which of these two currency pairs will react more strongly than the others.
As you can see, currency correlation gives you a general idea to club currency pairs that behave similarly or in inverse direction. But you should also pay attention to the fundamentals that will determine the intensity of the volatility fhat comes with these currency pairs.