In this article we’ll cover correlations in the currency markets and how an understanding of these relationships can help you diversify, hedge and develop trading strategies.
What is Correlation?
Correlation is a statistical measure of the relationship between two securities. Currency correlation shows the extent to which two currency pairs have moved in the same, opposite, or totally random directions, over a set time period.
Using this past statistical data on how two currency pairs relate to one another has predictive value and can help you both identify potential trade set ups and manage your directional exposure to risk.
Correlation is typically measured in decimal form on scale of -1 to +1 to give you a figure referred to as the correlation coefficient.
- A correlation of +1 shows that the two currency pairs will move in the same direction 100% of the time (a perfect positive correlation).
- A correlation of -1 indicates that the two currency pairs will move in the opposite direction 100% of the time (a perfect negative correlation).
- A correlation of zero implies that the relationship between the currency pairs is totally random.
Naturally, the stronger the positive or negative correlation, the greater the predictive value drawn from the analysis.
As with other indicators, the longer time frame used for the analysis, the more meaningful the data. Correlations over a 1 minute period are meaningless, while monthly and yearly data provide the most valuable insight.
A variety of free currency correlation tables are available for free on the internet.
Look for tables that can provide daily, weekly, monthly and yearly data. You can also create your own correlation tables using excel.
How understanding correlations between currency pairs can help you
- They can form the basis of a statistically high probability trading strategy.
- They can illustrate the amount of risk you are exposed to in your trading account. For example if you have bought several currency pairs with a strong positive correlation you are exposed to greater directional risk.
- You can avoid positions that effectively cancel each other out. For example EUR/USD and USD/CHF have a very strong negative correlation. If you have a directional bias, buying both EUR/USD and USD/CHF will counteract the moves in each pair and you will lose money on the spread.
- Understanding correlations can allow you to hedge or diversify your exposure to the market. In terms of diversification, if you have a directional bias you can spread your risk across two pairs that have a strong positive correlation. If you are looking to hedge a position (hold it with low risk of losses) you can take a position in a closely correlated pair. For example if you initiate a long EUR/USD position and it starts to go against you, you can hedge the position by buying a negatively correlated pair such as USD/CHF.
Examples of Trading Strategies Based on Correlation
- When two pairs are highly correlated, one can serve as a leading indicator to the price movement of the other. If you are watching two currency pairs that have a strong positive correlation and you see a sharp move in one pair, you can anticipate a possible move in the other. This is even more an even more powerful indicator in conjunction with another indicator. For example if one pair first pair breaks out above or below a major technical level of support or resistance, the closely positively correlated pair has a high probability of following suit.
- Price reversals. If you are watching two negatively correlated currency pairs and you see a significant upward price reversal in one pair you can anticipate a potential downward reversal in the other pair.
- Non-directional arbitrage strategy using currency correlations, where you wait for an abnormal divergence between two highly correlated currency pairs and buy one and sell the other, with the expectation that they will converge in price movement again.
Highly Correlated Currency Pairs
Examples of Strong Positive Correlations (Yearly Timeframe)
EUR/USD and GBP/USD (+ 0.89)
EUR/USD and AUD/USD (+ 0.81)
EUR/USD and EUR/CHF (+ 0.93)
AUD/USD and Gold (+ 0.75)
Examples of Strong Negative Correlations (Yearly Timeframe)
EUR/USD and USD/CHF (- 0.85)
USD/CAD and AUD/USD (- 0.88)
AUD/NZD and NZD/SGD (- 0.78)
USD/JPY and Gold (- 0.78)
Commodities that are Correlated with Currencies
The Canadian Dollar and crude oil have a positive correlation, due to the fact that Canada is a major oil producer and exporter.
Similarly, the Australian Dollar and gold have a positive correlation, because Australia is a significant gold producer and exporter.
Both gold and the Japanese Yen are viewed as safe havens in times of uncertainty and these two are also positively correlated.
Meanwhile, gold and the US dollar typically have a negative correlation. When the U.S. dollar starts to lose its value amid rising inflation, investors seek alternative stores of value such as gold.
Currency Correlations Change
Be aware that currency correlations can change over time for a variety of reasons. These often include fundamental factors such as changes in Central Bank policy and other economic or political events. Prior price relationships are never a guaranteed indicator of future correlation.
Understanding currency correlations can be an effective tool in developing high probability trading strategies and in managing risk. Experiment with highly correlated currencies and be sure to keep track of their correlation coefficients over the daily, weekly, monthly and yearly timeframes.