Correlations are calculations based on historical pricing data that can tell us whether two currency pairs move in the same, opposite, or totally random direction over time.
These calculations provide useful for traders who want to diversify their portfolios and reduce risk, or simply want a confirmation for trading a specific currency pair.
The correlations can be strong or weak and can last for various stretches of time. The measure is reflected in a correlation number, which gives us an estimate of how closely pairs move together or whether they move in opposite directions.
The correlation coefficient ranges between -1 and +1.
- a correlation of +1 implies that the two currency pairs move in the same direction all the time (perfect positive correlation);
- a correlation of -1 implies that the two currency pairs will move in the opposite direction all the time (perfect negative correlation);
- a correlation of 0 means that there is no relationship between the movement of the currency pairs (random or independent).
How to use correlations to your advantage
– use correlations to avoid taking positions that cancel each other out. An example would be going long both EUR/USD and USD/CHF, which move in opposite directions almost all the time.
– avoid trading two highly correlated pairs in opposite directions. This will cancel your gains because one pair’s losses will eat all of the other pair’s profits.
– avoid increasing your risk exposure by taking opposite positions on two negatively correlated pairs. For example, by buying EUR/USD and selling USD/CHF, you are basically expressing one trading idea and doubling your position size on it.
– use correlations to diversify your risk exposure. For example, buying two different currency pairs that manifest an imperfect correlation (like EUR/USD and GBP/USD) allows for more diversification and marginally lower risk.
Keep in mind: a well-developed trader has to understand how different currency pairs move in relation to each other in order to make better trading decisions in regards to leverage, hedging or diversification.
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