Correlation in forex trading is a controversial theory that every experienced trader talks about. Some traders argue that there is no correlation between currency pairs while some traders say there is. Which one is right? In the whole section, we will see what a correlation in the forex market is and how it will affect your trading activity.
24 March, 2020, | AtoZ Markets – Correlation is the statistical measure between two different financial assets. It determines how two different financial assets move towards a direction. A positive correlation exists when two separate financial assets move in the same direction. For example, there is a positive correlation between the USDCAD and the price of crude oil. Conversely, there is a negative correlation between EURUSD and USDCHF price.
Correlations in currency pairs influence the volatility of the market. Therefore, traders use it as a strong investment diversification tool. It is a key element of risk management for forex traders. Before, proceeding further about the currency correlation, a trader should understand how the currency pair forms in the market.
Currency Pairs in Forex Market
If you look at the MT4 or MT5 chart, you will see the tradable instrument like a pair. The currency pair is a combination of two different currencies of two different countries. For example, in the EURUSD chart, the first currency represents the economy of the Eurozone and the second currency represents the economy of the US. Therefore, the price movement in EURUSD will depend on the economic activity in the Eurozone and the US. If any good economic activity comes from the Eurozone the EURUSD price will move up. On the other hand, any economic activity that is good for the US will create bearish pressure in the EURUSD price.
The same theory applies to every currency pair like GBPUSD, USDCAD, USDJPY, etc. Like EURUSD, GBPUSD price depends on the economic activity of the UK and the US. So if we consider the EURGBP price, there is no correlation as there is no US dollar between them.
Remember the EURGBP price derived from the EURUSD and GBPUSD price.
Major Forex Pair
The major currency pairs are the currencies from the world’s top leaders. There are almost 5-6 currency pairs that are treated as the major currency pairs. Therefore, other currency pairs are calculated from the price in the major Forex pair. The major currency pairs are- EURUSD, GBPUSD, AUDUSD, USDCAD, USDJPY, USDCHF, and NZDUSD.
Any positive economic activity in the Eurozone will affect the EURUSD price only. Therefore, the pair is unique and it will not affect other currency pairs. On the other hand, if any movement in the EURUSD happens for the US Dollar, it will affect other currencies.
For example, if US unemployment comes better than expected, the US dollar will be strong against the EURO. Therefore, the EURUSD price will move down. Moreover, as the movement happens for the US Dollar, the GBPUSD will move down as well. So traders in front of the chart will see the GBPUSD and the EURUSD to move in the same direction after releasing the news. As they are moving in the same direction, it seems like they are correlated.
Minor and Cross Forex Pair
These are forex pairs that calculated the value from the major forex pairs. For example, if EURUSD is at 1.15 and GBPUSD at 1.23, the EURGBP value would be 0.9349 (1.15/1.23).
This theory indicates that the value of minor and cross forex pairs come from the value of major forex pairs. So the main event happens in the major pairs only. As the value of minor and cross pairs come from the value of major forex pairs, there is no direct correlation between minor and cross pairs.
The correlation between currency pairs depends on the fundamental factors of each country. Fundamental factors related to monetary policy, fiscal policy, geopolitical news, trade balance, etc. mostly affect the correlation between two currency pairs. In the forex market, correlations are settled between perfect to negative. It is calculated from the theory that is known as a correlation coefficient. It ranges between -1 and +1.
- A perfect positive correlation stands for a correlation coefficient of +1. It indicates that the two forex pairs will move towards the same direction every time. For example, the correlation between EUR/USD and GBP/USD is almost positive. Therefore, if the US Dollar strengthens, both EUR and GBP will usually decline. Conversely, if the US dollar weakens, then both currency pairs will tend to strengthen.
- A perfect negative correlation stands for a correlation coefficient of -1. It indicates that the two forex pairs will move towards the opposite direction every time. For example, there is a negative correlation between EURUSD and USDJPY. Therefore, if the US Dollar strengthens, the EURUSD will go down and USDJPY will go up. Conversely, if the US dollar weakens, the EURUSD will go up and USDJPY will go down.
- Some currency pairs have zero correlation. Therefore, the movement between two forex pairs has no correlation at all. Therefore, they are completely independent.
How to Utilize Correlation in Forex Trading
If you are trading more than one currency pair, you are going through correlation. By using forex correlation, you can hedge your risk or you can diversify your portfolio. You can take smaller positions in correlated currency pairs rather than taking bigger risks in a single currency pair. It will reduce your overall risk, and it will help you diversify your portfolio. You should not put all of your eggs into one basket.
Besides retail Forex trading, lots of large financial institutes and multinational companies use forex correlation to choose the best currency pairs to hedge their foreign exchange risks. Companies need to operate many foreign exchange transactions, so it is crucial for them to minimize the risk associated with it. Most of the companies use forward, future and option as a methodology to hedge the risk.
Things are slightly different in retail trading. You can trade 1 standard lot on EURUSD sale. However, when you want to diversify your portfolio, you can sell EURUSD and GBPUSD both by dividing the lot size at 50%.
Forex Trading Strategy Based on Correlation
There are many forex trading strategies based on the correlation.
- We know some currency pairs are positively correlated. Therefore, a positively correlated pair will move almost the same way most of the time. If we see the EURUSD fall down from a resistance level, it is likely that the GBPUSD will fall as well. Therefore, by using the correlation, we are determining the direction of separate currency pairs. In positively correlated pairs, the one currency pair starts to move towards the direction, and another currency pair will follow it.
- Traders can get the reason for a price movement by using correlated currency pairs. For example, if news comes and the USD becomes stronger, we will intend to buy US dollars. As of the fundamental news, the EURUSD should move down. For more confirmation, we will see what the GBPUSD and AUDUSD are doing. If we see the GBPUSD and AUDUSD move drown we will be sure that the movement is happening due to the strength of the US Dollar. Therefore, we will find the weakest currency pair against the US dollar, and we will trade on that currency pair to gain the maximum benefit.
- On the other hand, we can use a forex correlation for diversifying our portfolio. For example, instead of buying 2 standard lot of GBPUSD we can buy 1 standard lot of GBPUSD and 1 standard lot of AUDUSD as a diversification of our portfolio.
The forex market is the world’s biggest financial market. Most of the participants in the forex market are big financial institutes, Central banks, insurance companies, and Forex brokers. For retail traders, forex trading is quite hard as their analysis might go wrong if the big players are not towards their direction. By using correlation, a retail trader can increase the probability of the movement of a currency pair. Therefore, traders need to follow strong money management and trade management skills, as is there a lot of uncertainty in the forex market.
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