Knowing Currency Correlations
April 30, 2009 by Hass67
Filed under Stock Market
Everything is interrelated in the forex markets. It is important for you to understand that the price action of each currency pair is not mutually exclusive.
Different currency pairs move relative to one another. You need to understand that different currency pairs are correlated. Correlation can be positive or negative.
Knowledge of the strength of this relationship and its direction can help you in developing your trading strategies. Correlation numbers have the potential to become a great trading tool for you.
Correlations are calculations based on past pricing data between different currency pairs. It is always a number between -1 and +1. These numbers can provide you with a lot of information that can maximize returns, minimize risk and help you avoid counter productive trading.
Lets make it clear with an example. Suppose USD/JPY and USD/CHF had a positive correlation of +0.83 last month. This number is close to +1 and means that both pairs are moving together most of the time in the same direction.
Since both the pairs move together, if you are trading USD/JPY and USD/CHF at the same time, it will double up your position if you go long or short on both at the same time. In other words, if you lose a trade on USD/JPY, the chances are that you will also lose the trade on USD/CHF 83% of the times.
Take another example. Suppose EUR/USD and USD/CHF have a negative correlation of -0.9 in the past month. Both the pairs are moving in opposite directions. If you go long on one, it is not a good strategy to go short on the other. It will only double up your position and increase your risk.
When investing in two pairs at the same time, try to choose such pairs that have correlations close to zero. This will make the two pairs almost independent of each other and you can invest in both of them safely.
Always keep this in mind that currency markets are constantly changing. The correlation between currency pairs also keep on changing. It would be a good idea to calculate the correlations between pairs on a monthly basis.
