Forex Correlation Strategy – Forex Strategies Explained

Forex correlation strategy, currencies that positively or negatively correlate, must be something you have stumbled upon while exploring Forex trading strategies.

The Forex correlation strategy turned out to be one of the most efficient hedging strategies.

This article will help you better understand what correlation is. Also, it shows you how to calculate correlation and, most importantly, how to implement this data into the Forex correlation strategy.

Implementing Forex Pairs Correlation to your Advantage

There are many advantages to getting to know the ropes of relations between Forex pairs. Before we look into Forex correlation strategies, here are several takeaways to outline the importance of correlation.

• Correlation is a statistical tool used to quantify the relationship that exists between two variables. In the case of Forex, the two variables are two currency pairs.
• There are positively and negatively correlated currencies. When pairs positively correlate, it means their prices are always going in the same direction. A negative correlation implies price movements in opposite directions.
• One of the main perks of understanding the correlation is that correlation can be used for hedging strategies and better portfolio management.

Defining Correlation 

Currency correlation helps to assess the risk of trading positions better. Correlation measures the link between two currency pairs. For example, it allows knowing if two currency pairs will move in a similar direction or not.

Two currencies will have a coefficient close to 100 if they move in the same direction and -100 if they move in opposite directions. The latter is also called inverse correlation. A correlation close to 0 shows that the movements of two currency pairs are unrelated.

How to Read the Correlation Table 

A correlation table is a tool that can help you check out the extent of the interdependence of the two forex pairs.

If the currency pairs coefficient is +1, there is a 100 percent positive correlation between the two currency pairs.

On the other hand, if the coefficient is -1, it implies the two forex pairs will have an inverse correlation 100% of the time.

Suppose the correlation table shows a high positive correlation of 0.96 for EUR/USD and GBP/USD. It implies that when EUR/USD goes up, the GBP/USD follows the trend 96% of the time.

On the contrary, if the table shows a strong negative correlation for EUR/USD and USD/CHF, it means when EUR/USD rallies, the USD/CHF takes the opposite direction.

The Correlation Coefficient is Ever-Changing

Currency pairs correlation stability is ever-changing.

As a rule, the pairs correlate either positively or negatively. Nevertheless, the correlation pairings can be stable over a long time, but that could suddenly change due to several important factors.

For instance, USD/CAD and USD/CHF could have a strong positive correlation over the whole year. But correlation coefficients can also decline considerably in a couple of months.

Here are the most important reasons for this:

• Correlation between specific currency and commodity asset
• The rate of currencies that makes up the forex pair
• Correlation of indexes and currencies like, for instance, the Dollar index, the S&P 500 Index, etc.
• Global economic and political factors
• Diverging monetary policies

Beware that the strong correlation today doesn’t mean a long-term trend.

That’s why you should always consider coefficients on a six-month basis. It allows for a broader perspective and more accuracy when determining the trends.

When trading pairs including CAD and USD, you should particularly be keen on the oil price changes. It’s simply because the United States and Canadian markets are sensitive to oil price movements.

Forex Correlation Strategy – How to use the data?

So how can currency pairs correlation help you improve your trading strategy?

Forex correlation strategy is one of the best hedging strategies.

Diversification of Forex markets’ currency pairs goes hand in hand with sound risk management. Furthermore, currency pairs correlation is one of the factors for successful hedging strategies when trading Forex.

For better risk management, it is important to know if the open positions of a portfolio are in correlation.

Let’s say you have opened trades on three highly correlated currency pairs.

Then you should anticipate that if one position hits stop loss, the other two have a high chance of losing as well.

In this case, it is essential to adjust the size of the positions to avoid a severe loss.

Hedging Strategies Using Correlation

A change in the correlation, mainly over the long term, can show that the market is changing. For instance, let’s say there is a strong correlation between EUR/USD and GBP/USD for a couple of months. And shortly after decorrelate. Therefore, it can signify the changing market sentiment for the European market as well as for the British pound.

Or let’s take, for example, the EUR/USD and AUD/USD correlation. This one is traditionally not 100% positive.

Therefore, mindful of this imperfect correlation, traders use these two pairs trading as a part of hedging strategies.

Instead of buying only EUR/US in the USD bearish trend, you should diversify and buy one EUR/USD pair and one AUD/USD pair.

Moreover, the different central bank monetary policies could mean the Australian dollar or the euro will be less affected once the USD starts to rally.

Or let’s take, for example, the EUR/USD and USD/CHF. These two pairs are perfectly negatively correlated. If the price of a pip move for EUR/USD is $10 for one lot and the price for a USD/CHF pip move is $9.24 for the same lot, you can use USD/CHF to hedge trading positions.

How to Calculate the Correlation Coefficient

Trading strategies based on forex correlation have developed with the internet and the growing power of calculation software.

If you want to calculate the currency pairs correlation, you can use Excel Spreadsheets. From the charting tool on the Forex trading platform, you can download the list of historical data for pairs that interest you.

You can add the data in two different columns, each for one currency pair. You can easily find the whole calculation process and formula on the internet.