Why is correlation important?

by | May 28, 2024 | Forex Education, Fundamental Analysis

Correlation

Why is correlation important?

This week I thought I’d try and explain the correlation between the various forex trading pairs. There are loads of pairs in ‘interesting’ areas and it’s important to remember to manage and understand the risk you are putting on the table.

In forex trading, correlation refers to the statistical relationship between the price movements of different currency pairs over a specific period. Correlation values range from -1 to +1, indicating the strength and direction of the relationship between currency pairs:

  1. Positive Correlation (+1): A positive correlation indicates that two currency pairs tend to move in the same direction over time. In other words, when one currency pair strengthens (rises in value), the other currency pair also tends to strengthen, and vice versa. For example, if EUR/USD and GBP/USD have a positive correlation of +0.80, it means that when EUR/USD rises, GBP/USD is likely to rise as well. Positive correlations can occur due to factors such as economic similarities, shared geopolitical events, or common market drivers.
  2. Negative Correlation (-1): A negative correlation indicates that two currency pairs tend to move in opposite directions over time. When one currency pair strengthens, the other currency pair tends to weaken, and vice versa. For example, if USD/JPY and EUR/USD have a negative correlation of -0.70, it means that when USD/JPY rises, EUR/USD is likely to fall, and when USD/JPY falls, EUR/USD is likely to rise. Negative correlations can occur due to factors such as economic divergences, contrasting monetary policies, or inverse relationships between currencies.
  3. Zero Correlation (0): A correlation value of zero indicates no relationship between the price movements of two currency pairs. This means that the movements of one currency pair have no predictable impact on the movements of the other currency pair. In forex trading, zero correlation is relatively rare, as most currency pairs are influenced by common factors such as overall market sentiment, economic data releases, and geopolitical events.

Understanding the correlation between currency pairs can be valuable for forex traders in several ways:

  • Diversification: Positive and negative correlations can be used to diversify trading portfolios by including currency pairs that have low or negative correlations with each other. Diversification can help reduce overall portfolio risk and minimise exposure to specific market trends or events.
  • Hedging: Traders may use negatively correlated currency pairs to hedge against risk and protect their positions from adverse market movements. For example, if a trader holds a long position in EUR/USD, they may enter a short position in USD/CHF (which tends to have a negative correlation with EUR/USD) to hedge against potential losses.
  • Trading Strategies: Correlation analysis can inform trading strategies by identifying currency pairs that are likely to move together or in opposite directions. Traders may use correlation data to confirm trade signals, filter trade opportunities, or adjust position sizes based on the degree of correlation between currency pairs.

 

Example of correlation chart

Source: Mataf

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Kind regards,

Thinus

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