On the forex charts, you see each currency pair moving in a particular direction, higher, lower, range-bound, etc. You often see two currency pairs moving in the same direction as well.
What if there were a direct relationship between the two currency pairs moving in the same direction — you could then use that knowledge to make trades based on it.
Forex correlation provides the means to see if there is a price relationship among various currency pairs. If there is a statistical way of showing this, we can use this correlation in our trading strategies: Such a correlation can help to reduce risk and to suggest alternative strategies.
If there were a perfect correlation between two currency pairs, that would mean that they move in the same direction all of the time.
If there is no correlation between two currency pairs, then they move in completely random directions with respect to each other at all times.
It’s the in-between perfect and random correlations that makes understanding currency pair correlations interesting.
Because it’s quite rare to find a 100 percent correlation, but an 80 percent correlation is a number you can work with.
As you can guess from the previous paragraph, forex correlations are related in terms of percentages.
Here is a typical forex correlation table:
Source: MyForex (this is a selection from the entire table – the period is one day)
You can enter levels of correlation in terms of percentages at the top of the chart to find which ones are closely correlated and which currency pairs have a low correlation.
For example, CAD/JPY correlates at 88.3 percent with USD/JPY. Now, knowing that these pairs are closely correlated, you would be wise to not trade both of them at the same time. Obviously, they are both going to move in the same direction, but they may not move to the same number of pips – i.e. if one gains 30 pips, and the other gains 20 pips, the losses on one pair will offset the gains on the other.
So you choose another forex correlation that is negative with respect to one of the first two pairs. Now you’re betting on separate correlations, with a much better chance of winning at both. And you avoid betting on different pairs that would cancel each other out – one winning, the other losing.
Correlations also permit you to make the best use of forex leverage. Trade currencies with secure levels of correlation, but go long or short in one pair and then hedge with a bet on the other.
You can even use forex correlation to cut losses. For example, if you are long in USD/GBP, and you see the trade isn’t working out, go long in a pair that has a strong negative correlation, and you will have a good chance of compensating for losses in the first pair. This is a classic trading technique, one that can cut your losses and save you money.
Then you can look for price reversals. Looking at two negatively correlated currency pairs, when a significant upward price reversal in one pair takes place, then you can anticipate a potential downward reversal in the other pair.
You can also use currency correlations to help you to decide when to enter or exit a trade.
Suppose you see that a currency pair is about to break through a significant level of resistance in an upward move.
You look at the other currencies closely correlated with it: Those with close correlations and those with negative correlations. If you see similar moves taking place with these other currency pairs, you know that a breakout is likely to take place, so you enter a trade.
You can observe correlated pairs once your trade is underway to determine if they are all moving in a related way, like the one described above, and then use that knowledge to exit.
Currency correlations change, and they change often
You should take advantage of currency pair correlations when you can, but you should be aware that they’re not carved in stone.
The correlation that worked well for you a week ago may have completely disappeared this week.
So you have to keep up with the changes. The broker you work with should publish updated correlation tables on a regular basis. Make sure you learn all you need from them before you use correlations in your forex trading strategy.
With that said, there are a few currency pairs that seem to stay correlated over long periods. You’ll notice that they all involve USD – that’s probably why they stay correlated, as USD often moves in the same direction against most currencies.
Here are the positive long-term correlations: EUR/USD and GBP/USD, EUR/USD and AUD/USD, EUR/USD and NZD/USD, USD/CHF and USD/JPY, AUD/USD and NZD/USD.
Here are the negative, long-term correlations: EUR/USD and USD/CHF, GBP/USD and USD/JPY, USD/CAD and AUD/USD, USD/JPY and AUD/USD, GBP/USD and USD/CHF.