These are the reasons why you should know about currency correlations
If you are a trader who observes currency correlation, which you should, you would know if two currency pairs move in the same, different, or in random directions in a given time frame. Currency pairs are called such because they will never come in as a single currency but in tandem. Some are always close together, while some are always against each other. There is a term called correlation coefficient, which refers to the way we compute correlations. The range is between -1 and +1. To make it simple, here is a guide on various currency correlation coefficient values:
- -1.0 = Perfect inverse correlation
- -0.8 = Very strong inverse correlation
- -0.6 = Strong inverse correlation
- -0.4 = Moderate inverse correlation
- -0.2 = Weak inverse correlation
- 0 = No correlation
- 0.2 = Insignificant correlation
- 0.4 = Weak correlation
- 0.6 = Moderate correlation
- 0.8 = Strong correlation
- 1.0 = Perfect correlation
Benefits of currency correlations
Now that we know what currency correlation means, we already know why it is essential to learn more about it. Let us discuss them further in detail:
- Become more profitable. With the help of correlations, you will become aware of the currency pairs that have inverse correlations. Hence, trading two currency pairs with inverse correlation will cancel each other out as they move against each other 100%. In layman’s terms, you might not see any profits since one wins, and the other loses, aside from the fact that you will pay two spreads. Do not put your efforts in vain.
- Leverages. This two-edged sword offers an opportunity to maximize your profits. However, it can also maximize your losses, so you must study the trade thoroughly before pushing through. For instance, you opened two currency pairs with a strong correlation. In a sense, it’s like using leverage where your possible profits can be twice as much if everything goes as planned. Again, your profit might be double, but so does your losses!
- Risk reduction. Understanding correlations also means that you understand why using different currency pairs in a leverage POV is helpful. You can use two currency pairs that have a strong correlation, such as 0.7. It reduces your risks through the imperfection between them. For instance, you can open two EUR/ USD short positions when you feel bullish on the USD. Shorting the EUR/ USD and GBP/ USD can help you delegate the risks. As the USD gets sold, the effect on the EUR will be more negligible against the GBP.
- Risk hedging. Yes, it means fewer profits. However, it also means fewer losses. For instance, you opened a long EUR/ USD position. Later on, it starts going against your favor. You can open a small long position that will move against the EUR/ USD position. In this way, you can rectify significant losses.
- Breakout and fake out confirmation. Traders know that entry and exit are crucial. Currency correlations can help in that department as they can confirm signals.
Capping off our lesson today with a cheat sheet
Remember that knowing currency correlations is essential, among other things you need to learn in trading. Let us end today’s lesson with a cheat sheet.
Here are currency pairs that usually have same movement: EUR/USD + GBP/USD, EUR/USD + AUD/USD, EUR/USD + NZD/USD, USD/CHF + USD/JPY, and AUD/USD + NZD/ USD.
On the other hand, here are the currency pairs that usually move against each other: EUR/USD + USD/CHF, GBP/USD + USD/JPY, USD/CAD + AUD/USD, USD/JPY + AUD/USD, and GBP/USD + USD/CHF. Best of luck, trader!