Currency Correlations and How to Take Advantage of it
What are Currency Correlations?
A statistical measure that defines how variables are related to one another is a correlation. Currency correlation defines how one currency is related to another and when the correlation coefficient is greater than the relationship is more closely aligned. This will help to make a better prediction and allows the trader to make a perfect move. The currency correlation is represented on a numeric scale.
How are currencies priced?
Currencies are priced in pairs, it is necessary for a trader to understand the relationship between currencies even though no currency pair moves from one pair to another.
For example, if currency pair “A” moves in the same direction as currency pair “B”, let’s assume that we are following the movement of currency pair A close. If we expect A to go up and then we bought it but since we are not following the pair “B” soon if it happens suddenly and we look at the technical or fundamental analysis and receive a signal that the pair will start to decline and therefore we have sold this pair. What will happen in the end is that we will end the trade on a profit from one pair and also a loss for the other pair because both are moving in the same direction. A similar situation may arise if we buy or sell two other currency pairs at a time when there is an inverse relationship that makes each of them move in the opposite direction to the other.
Once we know the quality of these relationships and how they change over time, we can take advantage of this advantage to control the degree of exposure of our investment portfolio.
The correlation coefficient relies on between +1 and -1. Correlation + 1 means that the currency pairs will move together in the same direction 100% all the time. Correlation – 1 means that the currency pairs will move in 100% opposite directions all the time. Zero correlation means that the relationship between the currency pairs is completely random.
If the correlation coefficient is positive but less than +1, then the currency pairs move in the same direction but not at all times. If this positive value is close to +1, it means that both pairs will move in the same direction most of the time.
If the correlation coefficient is negative but less – 1 this means that the currency pairs will move in opposite directions but not all the time. If the correlation coefficient is close to -1, this means that the currency pairs move in opposite directions in most cases.
So how do you take advantage of the relationship between currencies while trading Forex?
Well, if your speed is increasing or decreasing on the highway due to traffic congestion sometimes, this will not reflect the average speed that you can finish the road you walk every time you use it. The correlation between currencies is dynamic and may change at any moment. Learn about the relationship during the past few days and then compare it with the degree of relationship in the long term, say, for example during the past year. If the correlation coefficient in the short term is very different from the long term, this may allow you to trade … But how? Let us assume, for example, that the correlation coefficient between the currency pairs A and B is of a grade of 0.98 over the past year. This means that both pairs move in the same direction most of the time. When pair A moves up, B also moves up almost at the same speed, but suddenly we notice that during the past week or month the correlation coefficient between the pairs has become 0.10, meaning that both are moving in the same direction but at different speeds. For example, suppose two cars are moving in the same direction but one is traveling at 100 mph while the other is traveling at 10 mph. But we can assume that in the end, both cars will have to drive at the same speed. So what do we do? Well we’ll see either of them going slower and take it When we convert this example to forex trading, I assume that the two currency pairs are moving in the same direction, which was bullish with a correlation of 0.60 in the long term, but surprisingly, this relationship over the past few days fell to 0.20. In this case, we will see who moves slower and then buy it on the assumption that it will catch up with the others soon. On the other hand, the pair could be sold if conditions change.
FOREX CORRELATION TRADING TIPS
Some of the important factors to consider when creating a forex correlation trading strategy are,
1. Use Intermarket correlations to your advantage: Find markets that have strong positive or negative correlations with the exposure you are seeking, such as major stock indices. Forex trading, in many cases, may provide more liquidity and 24-hour access to the market.
2. Find currency markets with strong positive or inverse correlations: Correlations above +0.5 and below -0.5 suggest a strong correlation exists. Use those strong correlations for hedging exposures.
3. Diversify risk: If you want to diversify risk, look for markets with correlation figures between -0.3 and +0.3 as that suggested they are not correlated