Table of contents:
- 1 Calculate the correlation of forex pairs
- 2 What is a correlation calculator or correlation matrix?
- 3 The correlation of AUDUSD
- 4 So how can one trade correlations in the Forex market and profit from them?
- 5 Correlations to reduce exposure
- 6 Use correlations to profit from the strength/weakness
- 7 Conclusion of my article on correlation in currency pairs
As a forex trader, you should pay close attention to the correlations, i.e. the potential synchronicity of the currency pairs being traded. For example, if you have a short position in EUR/USD and also open a short position in GBP/USD, you increase the potential risk of the overall position, because EUR/USD and GBP/USD tend to move in the same direction. Let’s look at the current correlation coefficients:
Over the last 10 days, the correlation has been relatively low at 0.3 or 30%.
Calculated over the last 25 days, however, the correlation was already at 0.91 or 91%.
Calculated over the last 50 days, the movements of the two forex pairs are even closer and the correlation was 0.98 or 98%.
Let’s take a look at a chart that shows the two currency pairs EUR/USD and GBP/USD together. If you click on the daily chart of EUR/USD and GBP/USD and enlarge it, you will see the daily chart with the price movement of the two currency pairs over the last 50 days. In fact, you can see that the rates are mostly highly synchronized.
In the last 10 days (shown in the yellow box), the correlation of EUR/USD to GBP/USD is only about 30%. The reason for this low value can be seen in the chart: The euro has made new lows against the USD in the last few days, while the pound sterling has essentially trended sideways against the US dollar. Both currency pairs have thus no longer moved in unison.
We can look at the longer-term correlation on a weekly chart. If you click on the chart and enlarge it, you can see the price development of the two currency pairs over the past two years. Then there are phases of very close correlation, but sometimes EUR/USD or GBP/USD decouples from the price movement in step.
Interesting is the period in the summer of 2014, when the Pound Sterling began to fall against the US Dollar only 12 weeks after the Euro and thus made the turning point to falling prices.
Calculate the correlation of forex pairs
You can nicely chart and see the correlation between two or more currency pairs, just like I did above in the comparison of EUR/USD to GBP/USD.
But there are also some websites that offer a correlation calculator or show the correlation coefficients for the most important currency pairs. Here are some links to them:
- Correlation calculator from Investing.com
- Presentation of the correlations
- Correlation values
- Forex Correlations
What is a correlation calculator or correlation matrix?
A correlation calculator measures the correlations between currencies. You can also easily create it yourself in Excel by downloading the historical data for example via MetaTrader or ProRealTime.
With the help of the correlation calculator you can get a quick overview of the correlation between the respective currency pairs. In addition, you get an answer to two essential questions:
- How strong is the correlation?
- What direction does the correlation take?
The strength of the correlation should be used to measure the extent to which there is a correlation. The measure here lies between zero 0 (= no correlation) and one (= strong correlation).
The direction of the correlation indicates whether the markets are also moving in the same direction. If the correlation is positive, the markets move in the same direction. With a negative correlation, the markets move in the opposite direction. If the markets move in the same direction, there is a positive correlation. The measure here is therefore greater than zero to plus one (+1). If, on the other hand, the markets are moving in the opposite direction, this is called a negative correlation and the measure is therefore less than zero to minus one (-1). With a correlation of +1, both markets move 100% in the same direction. If the correlation is -1, the markets move 100% in the opposite direction. With a correlation of 0, the markets move completely randomly and independently of each other.
Currency pairs that have a negative correlation are therefore also called opposing currency pairs. These are therefore very well suited as hedges.
Due to the correlation matrix, it can be seen very clearly that EURUSD and GBPUSD have almost 100% correlation. This means that if you want to take a position in both currency pairs, you should definitely be aware of this fact. The same applies to EURUSD and USDCHF. These two currency pairs have an extremely high negative correlation. They are therefore opposite currency pairs. In day trading, you look at the same matrix, only in the 1 minute or 5 minute chart. I have personally created a correlation matrix, which shows me the correlations in the 30 second chart and the change of this to the average of the last 36 minutes.
The correlation of AUDUSD
In addition to the correlations between currency pairs, it is also always important to know what currency it is and whether it has an additional correlation to commodities. This is because some currencies have a high correlation with commodities, as the export of the respective countries is very dependent on 1-2 commodities. Among the known currencies these are the currencies AUD, CAD and NZD.
To come back to the correlation in AUDUSD, one must know that about 25% of GDP is generated in the commodity industry. This means that commodities have a significant influence on the currency. In the AUD, it is important to understand that this currency currently has a positive correlation of around 0.88 with iron ore. In recent years, the correlation has increased significantly once again.
An overview between the correlation of AUD and iron ore in the period December 2011 – December 2016.
But if you look at the period from December 01, 2011 to December 31, 2012, you can see that the correlation was almost zero or even negative at times. Therefore it is also important to know when the respective correlations are valid and also why. After all, iron ore exports have continued to increase in 2015, and an important threshold was probably also exceeded in September 2014. One must also always look at the entire cycle of commodity prices, which is of course determined by supply and demand. This also gives you a good picture in terms of iron ore and the correlation to the AUD. Furthermore, it is often the case on the stock market that falling prices cause a higher correlation than rising prices. This is related to the asymmetry in the mindset of many investors and is therefore a psychological phenomenon.
So how can one trade correlations in the Forex market and profit from them?
There is little point in knowing anything about correlations if you cannot profit from this knowledge as a trader. I know a lot of people who have an extremely high level of knowledge, but this knowledge has little value in terms of trading. The best example is analysts. Knowing more does not mean that you automatically become a better trader. But a correct understanding of correlations is essential. In my opinion, together with fundamentals, the most important component. In my opinion, it doesn’t make much sense to distinguish between correlations in day trading and swing trading, because the way they work is very similar.
Correlations to reduce exposure
Exposure is another expression of risk. So why don’t I write risk directly? I try to bring you closer to the language of the professionals over time. Because the first development already starts with the language and way of thinking. So you try to reduce the total risk at a certain point in time with the help of correlations. If you now know which currency pairs correlate with each other and how, you can use this to better control the risk. For example, it usually makes little sense to take a long in EURUSD and a long in GBPUSD, as this almost doubles the risk. If the chance of double performance is achieved by doubling the risk, then trading is usually not very meaningful. It is different if this increases the probability significantly.
Use correlations to profit from the strength/weakness
Another possibility in Forex trading is to use correlations in order to profit from emerging strength/weakness. If I know how the correlations of the currency pairs are for example in the smaller time units and I see that the Euro is quite strong at the moment, but another currency pair that also has the Euro as base currency is still a bit weaker, then I can buy this currency pair if it shows a long signal anyway. The probability is therefore good that it will gain even more strength. The same applies to weak currency pairs. In my opinion, this is even better in weak currency pairs.
What I find most interesting, however, is when a currency pair is completely disconnected from the correlation for a short period of time, and then even develops into a counter currency pair for a period of time. This approach also works very well for stocks using relative strength/weakness. There, one looks for stocks that show a certain weakness despite a strong market and thus develop their own dynamics or behavior. Such stocks are interesting. The same applies to Forex. Currency pairs that despite a strong base currency have a weakness and thus develop their own dynamics are interesting to trade. Paired with the above mentioned knowledge of the asymmetry of the investors one has a good tool at hand.
Conclusion of my article on correlation in currency pairs
Knowing and considering the correlations between the currency pairs traded is one of the more important tasks of a forex trader. Every additional position in trading can further increase the risk. But it can also minimize the risk. As a trader, the goal should always be to maximize performance while minimizing risk. With the help of the right applications of correlations, you can come a step closer to this goal. Correlations are also well suited for discretionary trading, especially in the small time units and thus for scalping.
Read my other articles about Forex Trading:
- 7 biggest mistakes in Forex Trading
- Best Forex Strategy For Beginners And Experienced Traders?
- Buy and hold forex trading Strategy
- Effect Of Emotions On Your Forex Trading
- Efficient Gap Forex Trading Strategy
- Forex Broker with High leverage
- Forex demo account
- Forex exchange market: Professional Guide
- Forex Signals experience – Worthwhile or not?
- Forex Spreads & Fees – How Expensive Is Trading?
- Forex Trading Correlations for more profit
- Forex vs. Futures – Strong Differences In Performance
- How Much Capital Is Required For Forex Trading? – minimum deposit
- How to avoid requotes from your Broker in Forex Trading
- How to become a Forex Broker
- How to choose the Right Position Size In Forex Trading
- How to find a good Forex Broker
- Learn Forex Trading: Instructions & Guide For Beginners
- Learn Risk & Money Management in Forex Trading
- List of 10 trusted Forex Brokers
- Martin Gale Strategy in Forex Trading
- Risk of Forex Trading: How dangerous is it?
- Risks on Weekends in Forex Trading
- STP Broker Comparison – The Best STP Brokers In Test!
- The 10 Most Common Reasons Why Beginners Make Losses In Forex Trading
- The best ECN Brokers for Forex Trading
- the best Forex Broker: These Are The Points That Matter
- The Most Traded Currency Pairs – Guide
- The Trading History of the Pound Sterling (GBP/USD)
- The trading history of the Swiss Franc (USD/CHF)
- The Trading History of the Yen (USD/JPY)
- Trading History of the AUD/USD
- Trading History of the EURO/USD history
- Trading History of the US Dollar (USD)
- What Are The Effects Of Different Levers In Forex Trading?
- What is Forex Trading? – Definition & Explanation
- What moves the forex exchange price | Influences of the Exchange rate
- Which Currencies Are Recommended For Beginners And Professionals?