One of many factors that must be taken into consideration when trading is the currency pairs correlation as it is a measure of how correlated or anti-correlated they are. The most common pairings between currencies, also referred to as major currency pairs, are: (GBP/USD), (EUR/USD), and (USD/JPY).
Correlation can help determine which markets to trade in order to diversify risk and better manage a portfolio. Currency correlations can often change from one day to another due to underlying market conditions, so traders need to stay informed of any changes.
How does currency pairs correlation work?
When two currencies have a high positive correlation then they will move in the same direction at approximately the same time. For example, if the price of currency A falls then currency B would also fall.
Conversely, currencies that have low negative correlation will often rise and fall in opposite directions at the same time. This is known as a ‘risk off’ environment which can be beneficial to currency traders because it provides opportunities for many different currency pairings.
However, when two currencies are positively correlated it results in less volatility since they tend to rise or fall together rather than one currency rising rapidly while another falls at the same time. This type of trading environment creates fewer trading opportunities because there are fewer differences between prices for each currency pairing which means there is less chance their price will change compared to other currency levels.
How to use currency pairs correlation
Currency pairs with either extremely low or extremely high correlation can be unprofitable to trade. When pairs are highly correlated it may result in one currency following the other causing either minimal opportunities or only short-term gains, which is good for scalping but not necessarily trading.
On the other hand, pairs with very low correlation create long term trends that can continue for many days creating significant trading opportunities; however, this form of trading requires large amounts of capital and great risk management skills because they are often volatile.
The main thing to keep in mind when looking at two currencies’ correlation is whether there will be greater volatility when price movement occurs between them. A higher volatility means more opportunity for traders to buy and sell during different price movements so it helps maximize profits while minimising risk, but it also increases the potential for losses.
When one severe price movement occurs in any one of the major currency pairs, such as (EUR/USD), it often triggers a chain reaction of other market participants trading the correlated pair of (USD/CHF) and can sometimes even trigger trades in (AUD/JPY) or (NZD/CAD).
Risks associated with currency pairs correlation
The foreign exchange market is huge, but it has many different players. It’s difficult to hedge against price movements when you are trading against so many people with thousands of transactions daily.
Correlation is the extent to which the currencies within a currency pair move in tandem with one another. It can be useful for traders because it makes forecasting easier if they can predict how other factors will affect multiple currencies at once. For example, the interest rates set by central banks have an impact on short-term volatility that can often work its way through pairs that might not normally be correlated.
However, everyone looking for correlations increases competition and dampens the importance of any genuine relationship between two results. Even rarer than finding a genuine correlation, would be finding one that can be relied upon.
The best time to look for correlations is during quiet periods when the market is steadier and less likely to be swayed by other traders looking for an advantage.
Since there is always a change in correlation between currencies, traders need to stay abreast of these changes and continue analyzing correlations each time they make a trade. New traders should contact a reputable online broker from Saxo Bank before trying out any trading strategies. For more information on their services and products, visit the Saxo Bank site here.