Correlation trading is a great way to expand your trading portfolio and enrich your trading strategy. Taking advantage of currency correlation can open new opportunities to benefit from the forex market. In correlation trading the goal is to discover currency pairs that are exceptionally connected to each other, implying that when one pair moves in one direction, the other moves in that direction as well or in the opposite direction.
Some currency pairs have a positive relationship – meaning they tend to move in a similar value direction. Other pairs have a negative relationship — when one currency pair climbs in value, the other tends to fall. Lastly, few currencies have no connection at all. This means that their individual price movements are random in relation to each other.
The relationships between currency pairs are marked on a correlation table by a coefficient. A coefficient of +1 between two pairs implies that they have a 100% positive relationship – they will always move in the same direction. Vice versa, a coefficient of -1 indicates full negative relationship – they always move in opposite directions. And finally, a coefficient of 0 signifies no relationship whatsoever.
Now you’re probably wondering what causes the linkage between currencies. Well, the reason connections exist between currencies is that they are exchanged in pairs. Keep in mind that we never exchange a currency by itself, so when you are trading a certain pair, its value is often derived from or co-related to other pairs which include one of its components. So EUR/GBP will likely be related to EUR/USD and USD/GBP. It’s also vital to understand that correlations change over time, so keeping tabs on their movement is also very important.
After establishing the basic concept of currency correlation, let’s see how it can be used in your trading.
There are three steps you should follow to harness the links between currency pairs to your favor:
- Find or create a currency correlation table that shows the correlation between currency pairs of your choice within the time frame that suits you.
- Recognize the currency pairs you intend to trade in.
III. Adjust your trading plans accordingly.
The last step can be done effectively in at least three different ways:
- If you find pairs that have a strong negative correlation – avoid taking positions that cancel each other out.
- On the other hand, you can use pairs with a strong positive correlation to double down on the same position.
- Use correlation for risk management – hedge a position on one pair with the same position on an opposite moving pair, or diversify your account by buying two pairs with a positive correlation.
It’s also helpful to familiarize yourself with different tools and gauges that will help you determine the correlations within a wide range of currency pairs – such as the base vs quote currency concept or the broad USD index.
It’s important to get to know all the major strategies of forex trading. Once you understand how currency pairs behave in relation to each other, you can enlarge your portfolio, mitigate your risks, and eventually, even double your profits.