Forex correlations are an important trading tool. If you don’t know what they are, they may be hurting your trading without you even being aware. Correlations show us which forex move together, which ones moves in opposite directions, and which ones have very little relationship to each other. This information then helps us determine which trades we should take, helps control risk, and may even provide additional trading opportunities not easily seen on the price chart.
Forex correlations are typically shown in a table, with values ranging from -100 to 100. A value of -100 (negative numbers are called inverse correlations) means two forex pairs move exactly opposite each other–when one rises the other falls, and when one falls the other rises. A value of 100 means two forex pairs move in sync–when one rises the other rises, when one falls the other falls. It is very rare to find an asset that has a 100 or -100 correlation to another asset. Although as figure 1 shows, there are a number of forex pairs which have very high positive or negative correlations to each other.
Figure 1. Daily Correlations (July25, 2013)
I consider anything over -/+ 70 to be a noteworthy correlation, whereas anything over -/+80 is a strong correlation. Using the chart above, find GBP/USD on the left and then locate the EUR/USD along the top, then scroll down to the box where the row and column meet. It shows that the correlation between the GBP/USD and EUR/USD is 89.6. That means that most the time, on a daily basis they move in sync with each other. This is important to know for reasons which will be discussed in the next section.
Now, locate the USD/CHF along the left, and then the EUR/USD along the top. Find the box where the row and column meet, and it shows that the correlation between these two pairs is -95.4. That means that they share a very strong inverse correlation. When the EUR/USD goes up, the USD/CHF goes down, and vice versa.
Sometimes there is no relevant correlation. If a pairs has a correlation value (positive or negative) less than 60 the correlation is not very strong, and as we approach 0 there is no correlation between the pairs at all. Take for example the NZD/USD and the EUR/USD; the correlation between these pairs is -1.7, which means there is no discernible correlation, on a daily basis, between these pairs. In other words, the NZD/USD rising or falling tells us absolutely nothing about what the EUR/USD might do.
Correlations tables are typically offered based on hourly, daily and weekly timeframes. All these timeframes provide valuable information depending on what timeframe you trade on. For short-term trading, the hourly and daily correlations will be the most important important.
It is also important to note that correlations change all the time. Pairs that have a very strong correlation right now, may not down the road. Therefore, it is important to monitor correlations frequently to be aware of the changing relationship between pairs.
Forex correlations and other forex statistics are available at http://vantagepointtrading.com/daily-forex-stats.
Why Forex Correlations Matter?
There are a number of reasons to care about forex correlations. The main reason I monitor them is to control risk. For example, you may think that by taking several trades at once you’re “diversifying.” That may not be the case though.
If you go long (buy calls) in the EUR/USD, GBP/USD and sell (buy puts) the USD/CHF you have essentially taken 3 very similar positions. If one goes against you, they will likely all go against you. You haven’t reduced your risk through diversification; you’ve actually tripled your risk!
Another reason forex correlations matter is that they can provide you with trades you may not have seen. For instance, you believe the EUR will appreciate against the USD (ie. the EUR/USD will go up), but you look at the chart and don’t see a great trade set-up. Since you know that the GBP/USD typically moves with the EUR/USD (based on the current correlation), you can also check out the GBP/USD to see if there is a better trade set-up. You may also want to see if there is a trade set-up to go short (buy puts) in the USD/CHF since it typically moves in the opposite direction of the EUR/USD. High correlations (positive to negative) provide you with alternative trades; choose the one with the best trade set-up.
I also like to use forex correlations to confirm trades. Upon finding forex pairs with high correlations, I will use one pair to confirm trades in the other. For example, if the EUR/USD is rising, and I want to go long (buy calls), I also want to see the GBP/USD rising. Since these pairs are highly correlated they should be moving together. If they aren’t, it warns me that maybe I should look more closely at my trade. It doesn’t mean I won’t take the trade–since correlations do change and two pairs never move perfectly in harmony– it just means I better have very good reasons for taking the trade (as you always should anyway).
Correlations can be a complex statistical topic, but hopefully this introduction gets you familiarized enough with the concepts to do a bit of homework on your own as well. Check correlations studies frequently to be aware of relationships between forex pairs which may be affecting your trading. Use the correlation data to control risk, find opportunities and filter trades. If you are having trouble seeing how correlations work, try looking at the figures in the correlation tables and then pulling up price charts of the two forex pairs in question. Notice how the pairs move relative to one another; doing this will help create a general understanding of correlations.