What is Currency Correlation?
In the forex market, correlation is a statistical measure of how two currencies move in relation to each other. Currency pairs can move in the same direction, in opposite directions, or so randomly that they become difficult to predict. It is essential to understand correlation because you trade currencies in pairs on trading platforms like HFM, so no currency is ever isolated.
Understanding the Correlation Coefficient
Correlation is measured using a statistical computation called the correlation coefficient. It ranges from -1 to +1 and measures how strongly two variables, in this case currencies, are related.
A perfect correlation of +1 shows that two currency pairs will always move in the same direction all the time.
A perfect negative correlation indicates the opposite; they will always move in opposite directions 100% of the time.
A correlation coefficient of 0 indicates two currencies will not affect each other; they have No or Zero correlation. Such currencies are independent and behave randomly. This means it is impossible to know how they will behave in relation to each other or other currencies.
Why Understanding Correlation is So Important
We have insisted that understanding correlation is important for all forex traders, but why? The first reason is risk management. Understanding correlation means you can avoid amplifying your risks unknowingly. For example, it stops you from trading highly correlated pairs in the same direction. Doing this means you are doubling down on your position in a single move and also doubling down on potential losses.
The second reason is diversification. Correlation can help you understand which currency pairs to include in your portfolio when trading forex. Many traders include negatively correlated currency pairs because that offsets losses in one pair against gains in another.
Correlations Change
A trader might tell you that two currency pairs have a specific correlation and that is how it has always been. Understand that correlations can change at any time. Global economic factors and market sentiment are never static and can change by the day or even the hour. A strong correlation today is one news cycle away from being a weak or negative correlation tomorrow.
You can avoid trading incorrectly based on a stale correlation by using a trailing correlation. You can see how two currency pairs have performed against each other in the past six months to better understand how they are likely to behave in the future. This will also let you know how much to invest if you do take the risk.
Correlation helps traders understand how two currency pairs perform against each other. Understanding this can help you minimise risks, get into better positions, and learn which currency pairs to include in your portfolio. You can either check the charts or calculate the correlations yourself, with the latter being the better option for savvy investors.