Currency pairs correlation 101


This is a question I have received from one of my trainees from the #100TraderChallenge training:

Yagub, one of things I usually get into a problems is I get into trades with currency pairs that are correlated and end up in a mess. Is there a checklist that anyone has done that shows these correlations?

To be an effective trader, understanding your favorite trading instrument's sensitivity to market volatility is important. This is especially so when trading Forex.

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As Forex trading instruments are priced in pairs, no single pair trades completely independent of the others. There is always a correlation between the pairs, commodities or even larger inter-correlated trading instruments. Once you are aware of the currency pairs correlation and how they change, you can use them control your overall portfolio's exposure.

correlation_coefficientThe reason for this interdependence of trading instruments is easy to notice: if you were to trade the Euro against the CHF(EUR/CHF pair), for example, you are actually trading a derivative of the EUR/USD and USD/CHF pairs; therefore, EUR/CHF must be somewhat correlated to one if not both of these other currency pairs. However, the interdependence among Forex instruments stems from more than the simple fact that they are in pairs. While some currency pairs will be directly correlated, other currency pairs may be inversely correlated, which is in essence the result of more complex forces.

 

Just a little bit of statistics will do!

Correlation is the statistical measure of the relationship between two items, in finance between two securities. The correlation coefficient ranges between -1 to +1.

*    +1 correlation coefficient implies that the two trading instrument are directly correlated to 100% accuracy (in our case I will call it +100)

*    -1 correlation coefficient implies that the two trading instrument are inversely correlated to 100% accuracy (in our case I will call it -100)

Major Pairs Hourly Correlation  (click to enlarge) Major Pairs Hourly Correlation (click to enlarge)

Although currency pairs correlation coefficient changes from time to time significantly, it is often better to read these correlations on daily or even weekly time-frames.

Major Pairs Daily Correlation  (click to enlarge) Major Pairs Daily Correlation (click to enlarge)

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