Have you ever noticed that when a certain currency pair rises, another currency pair falls? Or that sometimes when one pair falls, another pair seems to copy its movement and falls too. If the answer is yes, you have witnessed an example of a Forex currency correlation.
What is currency correlation?
In the financial world, correlation is a statistical measure of how two securities move relative to each other.
Forex currency correlations indicate whether two currency pairs move in the same direction, in the opposite direction, or completely randomly, in the same period of time.
Unless you are considering trading only one currency pair, knowing the correlations is crucial so that you know how the different currency pairs move relative to each other.
In this lesson, you will learn what currency correlation is and how it can be used to help you become a smart trader.
The correlation is calculated with the correlation coefficient, which ranges from -1 to +1.
- A perfect positive correlation (correlation coefficient of 1) implies that the two currency pairs move in the same direction 100% of the time.
- A perfect negative correlation (correlation coefficient of -1) means that the two currency pairs move in opposite directions 100% of the time.
- If the correlation is 0, it is said that the movements between two currency pairs do not follow any correlation, and that they are completely independent.
How to read the correlation tables of Forex currency pairs?
If you like to learn things visually, take a look at the following tables, which show the relationship between the different currency pairs based on different time frames.
Remember that the correlation is presented in decimal format based on the correlation coefficient, which ranges between -1.00 and 1.00. A coefficient close to 1 indicates that the two pairs have a strong positive correlation and are likely to move in the same direction.
Similarly, a correlation coefficient close to -1 indicates that the two pairs have a strong negative correlation, causing them to move in opposite directions.
A coefficient close to zero indicates a very weak relationship between the two.
Examples of Forex currency correlations for the major pairs are shown in the following tables:
Correlations of the EUR/USD and other pairs
Correlations of the USD/JPY and other pairs
Correlations of the USD/CHF and other pairs
Correlations of the GBP/USD and other pairs
Correlations of the USD/CAD and other pairs
Correlations of the AUD/USD and other pairs
Correlations of the NZD/USD and other pairs
Correlations of the EUR/JPY and other pairs
Correlations of the EUR/GBP and other pairs
Are you unknowingly doubling the risk in your currency trading?
When you are trading multiple currency pairs simultaneously, always make sure you are aware of your risk exposure.
You may believe that you are spreading or diversifying your risk by trading different pairs, but many pairs tend to move in the same direction.
Let’s look at an example involving two highly correlated pairs in the 1 week time frame. The EUR/USD and the GBP/USD.
A correlation coefficient of 0.94 obviously indicates that there is a high correlation in these pairs. To show you that the numbers don’t lie, below are the 4-hour price charts of both currency pairs for the same period. Notice how the two pairs move in the same direction… up.
Returning to the topic of risk, we can see that opening a position in both EUR/USD and GBP/USD in the same direction is the same as doubling your position.
For example, if you bought 1 lot of EUR/USD and another lot of GBP/USD, what you are basically doing is buying 2 lots of EUR/USD, since both the EUR/USD and the GBP/USD move in the same direction.
It is also not good to buy the EUR/USD and sell the GBP/USD at the same time, because if the EUR/USD rises strongly, then the GBP/USD will probably rise as well.
If you think that your profit or loss will always be zero, you are wrong. The EUR/USD and GBP/USD have different pip values and although both pairs are highly correlated, it does not mean that they always move in the exact same pip range.
Volatility within currency pairs is fickle. EUR/USD can skyrocket 200 pips, while GBP/USD can only go as high as 190 pips. If this happens, the losses from your GBP/USD trade eat away most of the EUR/USD profits.
Now let’s imagine that the EUR/USD is the pair that goes up 190 pips, while the GBP/USD has a bigger move of 200 pips. You would have ended up with a loss!
Going long on one pair and going short on another pair that are highly correlated is extremely counterproductive.
Let’s take a look at another example. This time with the EUR/USD and the USD/CHF.
We have just seen that there is a strong positive correlation of EUR/USD with GBP/USD, while EUR/USD has a very negative correlation with USD/CHF.
If you look at the correlation table, they have a perfect correlation coefficient of -1.00. There is nothing more opposite than that.
EUR/USD and USD/CHF are like fire and water. These two pairs are moving in opposite directions. To see it, take a look at the following graphics:
Opening opposite positions in two negatively correlated pairs is the same as opening positions in the same direction in two positively correlated pairs.
Buying the EUR/USD and selling the USD / CHF would be the same as doubling one of your positions.
For example, if you buy 1 lot of EUR/USD and sell 1 lot of USD/CHF, it is basically buying 2 lots of EUR/USD, because if the EUR/USD goes up, then the USD/CHF goes down, and you will be making money twice.
However, it is important to recognize that you are increasing your exposure to risk in your account.
Going back to the example, if the EUR/USD falls your two trades would end losing money.
On the other hand, buying (or selling), both the EUR/USD and the USD/CHF, at the same time is usually counterproductive, since you are basically canceling your trades.
Because the two pairs are moving in opposite directions, on the one hand you are going to make money, but on the other you are going to lose money.
How to use Forex currency correlations in your trading?
Use the following table as a guide for interpreting the different values of the currency correlation coefficients.
|-1.0||perfect inverse correlation|
|-0.8||strong inverse correlation|
|-0.6||high inverse correlation|
|-0.4||moderate inverse correlation|
|-0.2||low inverse correlation|
So now you know what currency correlation is and how to read the correlation tables. But we are sure that you are wondering how to use currency correlations to have more successful trades. Why do you need to know the currency correlation and incorporate it into your trading?
There are many reasons:
Eliminate counterproductive trading
Using Forex currency correlations can help keep you out of positions that cancel each other out. As the table above shows, we know that EUR/USD and USD/CHF are moving in opposite directions 100%.
Opening a long position on EUR/USD and USD/CHF is useless and costly. In addition to paying the spread twice, any movement in price would cause your positions to cancel each other.
Take advantage of its benefits
You have the opportunity to double positions to maximize profits. Once again, let’s take as an example the 1-week chart in EUR/USD relative to GBP/USD.
These two pairs have a strong positive correlation. Opening a long position on each pair is like trading the EUR/USD and doubling the position.
Understanding the correlations also allows an investor to trade different currency pairs. Instead of trading only one currency pair, you can spread risk by trading two pairs that move the same way.
For example, a trader may consider pairs that have a strong or very strong correlation (around 0.7).
For example, the EUR/USD and the GBP/USD. The correlation of these two currency pairs gives you the opportunity to diversify, which helps reduce risk. Let’s say the USD is on the rise.
Instead of opening two short positions on the EUR/USD, you could go short on the EUR/USD and also on the GBP/USD, protecting yourself from risk and diversifying your global position.
In the event that the US dollar is on the rise, the euro could be affected to a lesser extent than the pound.
Although hedging can cause the trader to make lower profits, it can also help minimize losses. If you open a long position in EUR / USD and it starts to go against you, opening a small long position in a pair that moves in the opposite direction to EUR/USD, such as USD/CHF, could be positive as you will avoid having significant losses.
Also, you can take advantage of the different pip values for each currency pair.
For example, while EUR/USD and USD/CHF have a -1.0 inverse correlation, their pip values are different. Assuming you trade a mini lot of 10,000, a pip for EUR/USD is worth $1, while a pip for USD/CHF is worth $ 0.93.
If you buy a mini lot of EUR/USD, you can hedge your trade by buying a mini lot of USD/CHF. If the EUR/USD falls 10 pips ($10), your trade in the USD/CHF would be giving you $9.30.
Instead of losing $10, you would now be losing $0.70.
Despite all this, coverage has some downsides. If the EUR/USD rises, your profit is limited due to the losses of your position in the USD/CHF.
Also, the correlation can weaken at any time. Imagine if the EUR/USD falls 10 pips, and the USD/CHF only rises 5 pips, in this case, your account would be having a bad time.
So be careful what you cover.
Forex currency correlations change over time
The Forex market is like a patient suffering from bipolar disorder.
Although the correlations between pairs can be strong or weak for days, weeks, months, or even years, they can change when you least expect it.
The strong correlations seen in one month may be totally different the next month.
Look at the following table.
Compare the correlation coefficients for a currency pair in different time frames.
Do you notice something? In most cases, they change depending on the time frame we are analyzing. So we can ensure that the currency correlation changes, and it does so frequently.
And they can change dramatically in a short period of time, as you can see by examining the EUR/USD in the 1 month and 3 month interval.
Due to the constant changes in market sentiment, make sure you are aware of the changes in correlations.
For example, during the weekly time frame, the currency correlation between USD/JPY and USD/CHF was 0.22. This is a very low correlation coefficient and would indicate that the pairs have negligible correlation.
However, if you look at the quarterly data for the same time period, the number increases to 0.52 and then 0.78 for six months, and finally 0.74 for one year.
In this example, you can see that these two pairs had a break in their long-term correlation relationship. What was previously a strongly positive long-term correlation weakens in the short term.
If we look at EUR/USD and GBP/USD, the weekly period shows a very strong correlation with a coefficient of 0.94. But this relationship deteriorates in the monthly period, falling to 0.13, although in the three-month period it goes to a solid 0.83, to deteriorate again after six months with a weak correlation.
Now let’s look at an example of how the correlations of currency pairs can change dramatically. Let’s take a look at the following table and specifically at USD/JPY and NZD/USD.
The one-year correlation coefficient between both currency pairs was -0.69. But if you look at your monthly correlation, the correlation coefficient is positive. So be careful.
Currency correlations change for many different reasons.
Summary on Forex currency correlations
As if they were synchronized swimmers, some currency pairs move correlatively with each other. And just like magnets with the same poles touching, other currency pairs move in opposite directions.
When trading multiple currency pairs simultaneously, the most important thing is to make sure you are aware of your risk exposure.
You may believe that you are diversifying risk by trading different pairs, but you should know that many of them tend to move in the same direction.
Trading pairs that are highly correlated magnifies the risk.
Correlations between currency pairs can be strong or weak and last for weeks, months, or even years. But it is important to know that they can change at any time.
Keeping up with currency correlations can help you make better decisions or diversify your trades.
Some points to remember
- The coefficients are calculated using the daily closing prices.
- Positive coefficients indicate that the two pairs are positively correlated, which means that they generally move in the same direction.
- Negative coefficients indicate that the two currency pairs have a negative correlation, which means that they generally move in opposite directions.
- Correlation coefficient values close to 1 or -1 mean that the two pairs are highly related.
Examples of pairs going in the same direction:
- 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
Examples of pairs going in opposite directions:
- 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
When trading highly correlated pairs, make sure that you follow all the rules, and that you adhere to your risk management rules.
You can learn more about the Forex market and currency trading in the following tutorial: Forex Guide for Beginners