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TE14 - Are You Doubling Your Risk Without Knowing It?

"Trading multiple currency pairs can make forex trading a lot more exciting. Depending on the assets that you are trading, there is a good chance that the profits can be increased greatly. However, in doing so, traders do not realize whether they are taking on more risk. Of course, logic dictates that when you have an exposure in more than one currency pair, you are indeed taking on more risk. But besides this, there is another aspect that many traders do not know. This is to do with the concept of currency correlations. Currency correlations basically dictates, based on mathematical formula on how two currency pairs will behave. The behavior can be either positive, meaning that the two currency pairs move in the same direction, or negative, meaning that the two currency pairs move in opposite directions. Without knowing this relationship, if you take on multiple positions, there is a good chance that you are doubling your risk rather than doubling your profits."

Many traders prefer to focus on multiple currency pairs than just one. This is because of the basic reasoning that the more currency pairs you have a stake in, the better your chance of making a profit.

After all, if you think that you have a working trading system, then there is nothing to stop you from applying this to your set of favorite currency pairs and make profit from it. But there is a fundamental flaw in this approach.

For example, you might have a position in currency pair A and a currency pair B. You might think that your trading system is telling you that you should be long or short on both the currency pairs. As a result, you would end up with two long positions or two short positions.

But if you look closer to the currency pairs that you are trading, you might find that these currencies have inverse correlation. In other words, they exhibit a behavior of moving in opposite direction.

As a result of your positions, you would end up with one trade’s losses that will offset the profits of the other or vice versa. You might be able to get the general view by now that correlations or understanding how currency pairs behave is critical to your trading success.

Many traders using the above approach without understand currency correlations. This in turn can lead them into thinking that they will be making more money. In reality, traders are basically taking too much risk.

So, now comes the question on how you can avoid this trap.

The simple answer to this is to look at the currency correlations.

Let’s look at the currency correlation chart once again. What you see from the below chart is a list of currency pairs and their correlations.

TE14 01 Currency Correlations

Currency correlation chart

 

In the above chart, let’s take for example, XAUUSD and the GBPJPY. What you see here is a negative correlation of -91%. What this means is that when gold prices rise, the GBPJPY drops and vice versa.

A best way to illustrate this is by comparing the price chart of both these assets.

TE14 02 XAUUSD GBPJPY

Comparison of XAUUSD and GBPJPY

 

The blue line represents the GBPJPY chart while the orange line represents the price of gold.

You can see how these two assets have an inverse correlation. The correlation coefficient of -91% means that they are very strong correlated. As a result, you will see that when gold prices rise, GBPJPY tends to fall and vice versa.

Now if you traded both these assets in isolation, there is a good chance that you might not have even noticed this negative correlation. Thus, if you had the same positions on both these assets, you could end up with losing twice your money.

On the contrary, if you had a long position in gold and short position in GBPJPY, chances are that you would be able to make twice the profits, if your technical analysis was correct.

Many traders do not pay attention to these factors. It could be that traders are too busy chasing profits that they forget the fundamental concepts or that they simply do not understand how currency correlations work.

Now comes the question of what to do with this information.

Firstly, you need to make sure that you have a list of currency pairs or assets that are either positively or negatively correlated in a strong way. This would help you to get a better understanding of what currency pairs to trade in one direction and what currency pairs to trade in the other direction.

Based on this, you can then conduct your own technical analysis or apply your own trading strategy and pick those trades that coincide with the correlation between the assets. While this might seem hard work, it will pay off in the long term.

This is because when you are correctly positioned as per the correlation coefficients, it will help you to double your money rather than doubling your risk. You can see how risk and rewards are inversely correlated.

Having said the above, traders should also pay attention to the volatility of the currencies in question. For example, just because XAUUSD and GBPJPY are inversely correlated doesn’t mean that they will move the same length in opposite directions.

But since you identified that these assets are inversely correlated to each other you would be able to pay attention to the technical and the fundamental aspects that determine the prices in each of these assets when trading.

Read 665 times Last modified on Monday, 05 August 2019 09:32

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