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TE13 - Currency Correlation Explained

"Currency correlation is a method of applying correlations to understand which currency pairs exhibit the same behavior. Currency pairs can be positively or negatively correlated to each other. What this means is that positively correlated currency pairs move in the same direction. Meanwhile, a negatively correlated currency pair moves in the opposite direction. Correlations are often found in different markets and not just confined to the forex markets. But in the forex markets, you will find correlations being used more because of the fact that forex markets works on the basis of currency pairs. Thus, there is a good chance that a base currency in one currency pair can become a quote currency in another currency pair and vice-versa. In this article, we give you the basics of currency correlations and how you can use these to your advantage when trading the forex markets. While correlations might seem a bit complex, they are actually very simple."

Currency correlation is defined as the degree by which one currency is interrelated to another. Because in the forex markets, you trade currency pairs, one of the currencies is often used with other currency pairs as well.

In technical jargon, correlation is the numerical measure of the relationship between two variables. Correlations or correlation coefficient is measured between +1 and -1. When a currency pair has a coefficient of +1, it means that two currency pairs move in the same direction.

Likewise, when a correlation coefficient is -1, it means that both the currency pairs move in the opposite direction.

The coefficient value is generated based on a mathematical formula which gives rise to the correlation coefficient.

While the currency correlation might seem a bit complex and intimidating at times, it is very simple. You do not have to make use of math to derive the correlation values. Now a days, there are many technical indicators that can do the work for you.

You simply need to look at the correlation values to understand what currency pairs are likely to move in the same direction and which currency pairs move in the opposite direction.

What are the uses of currency correlations?

Currency correlations can help you to improve the results of your trading vastly. But in order for this to happen, you should have strong foundations in technical analysis. Once you have managed to get the levels in one currency pair, you can then look to the currency correlations to pick other currency pairs that move in the same or the opposite directions.

Currency correlations can be very beneficial especially when trends are strong.

Typically, the correlations can develop across different time frames. There is also a chance that correlations can change depending on the time frame that you are using.

Why do currency correlations work?

Currency correlation works because of the way the forex markets work. In the currency markets, you will be trading the currency pairs.

For example, if you are trading the EURUSD currency pair, and if the USD is trending strongly, you can expect other USD based currency pairs which will also behave in the same way.

This currency correlation can be even stronger, when you look at cross currency pairs.

The basic premise of the currency correlations is due to the base or the quote currency. Another example to illustrate this is as follows:

If you are long on GBPUSD and long on USDJPY, then it automatically means that you can also be long GBP/JPY. This happens when you remove the common, USD currency to both.

Thus, by just looking at the two currency pairs, you can also get a fair idea of how the GBP/JPY currency pair will behave.

How does currency correlations look like?

Below is an example of the currency correlation chart.

TE13 01 Currency Correlations

Example Currency correlation chart

 

The chart above shows the currency correlation in detail. What you see is that the values, expressed as a percentage. Positively correlated currency pairs are those that move in the same direction (in the same trend).

A negative correlated currency pair is one which moves in the opposite direction.

The correlation coefficients here are expressed as a percentage, instead of just +1 and -1.

As we mentioned earlier, correlations can change depending on the time frame of your choice. In the above example, you can see that the correlations are shown on a daily time frame chart, over the past 30-day periods.

This is another aspect to bear in mind. Correlations also need to focus on a certain lookback period. For example, the correlation can greatly change if you are looking at a 30-day period or when you are looking at a 5 day period.

Typically, currency pairs that have a correlation of 90% or 0.9 (+ or -) tend give the best results as they move in the same or opposite direction with the same amount.

Thus, looking at the above chart, you can see that the USDCAD currency pair is inversely correlated to gold (XAUUSD). Thus, when you see that gold prices are rising, you can expect the USDCAD to fall.

What this basically tells you is that the U.S. dollar is weaker, against both gold and the Canadian dollar.

The currency coefficients basically give you what currency pairs to look at. You can then apply your own technical analysis on the correlated currency pairs and trade based off those levels as well.

From the above, you can see that currency correlations can be a great way to improve the results of your trading, rather than trading just individual currency pairs.

Read 710 times Last modified on Saturday, 03 August 2019 08:15

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