Currency Correlation And It's Use In Forex Trading
Currencies are priced in pairs, no single pair trades completely independently of the others. This makes the understanding of correlation very important.
For example, currency pair "A" moves in the same direction as pair "B" and we have been following up pair A's move very closely. We expect it to go up and we buy. We have not been following up pair "B" so closely and suddenly we look into that and the fundamentals or technical analysis suggests us that this pair may go down. We short sell. What eventually would happen that we would end up having profit on one pair and loss on the other as they moved in same direction. Similar case would happen if we simultaneously go long or short on two pairs which move in opposite directions.
Once we know about these correlations and their changes with time, we can take advantage of them to control our portfolio's exposure.
The correlation coefficient ranges between -1 and +1.
A correlation of +1 implies that the two currency pairs will move in the same direction 100% of the time. A correlation of -1 implies the two currency pairs will move in the opposite direction 100% of the time. A correlation of zero implies that the relationship between the currency pairs is completely random.
A positive figure but less than +1 means that the currency pairs generally move in same direction but not always. A value closer to +1 means that most of the time they move in the same direction.
A negative figure but more than -1 means that the currency pairs generally move in opposite direction but not always. A value closer to -1 means that most of the time they move in opposite directions.
How to use currency correlation when you are trading Forex?
Well, your slow speed because of an occasional traffic jam on the expressway does not really indicate that the average speed you would end up on the road will be same. The correlation are dynamic and change every moment. Take a note of the correlation of the past few days and compare it with the correlation value in the long term, say past one year. If the short term value is far different from the long term value, may be it's offering you a chance to place a trade... but how? Let's say that currency pairs A and B has a correlation value of 0.98 during past one year. It means that they both move in almost the same direction. When currency pair A moves up, currency pair B also moves up with the same speed. Suddenly you notice that during the past one month or one week the correlation value of the currency pairs A and B is 0.10 i.e. moving in the same direction but with a different speed. To clarify as an example let's say two cars are moving towards the same destination, one is moving at 100 miles/hr and another at 10 miles/hour. But we can assume that ultimately both may have to catch up on the speed (similar speeds). So what do we do? Well, we find out which one is slow and ride that.
When we convert this car example to currency trading, suppose two currency pairs move in the same direction and have been moving up with a correlation over 0.60 in the long-term and we find that suddenly the correlation value in during the past few days has become 0.20, we just see which currency pair's movement (increase is slow) and we could buy that. On the other hand we could short-see another currency pair.