Why Currency Correlation Is Important in Forex Trading

Currency correlation as it pertains to currency pairs can have major consequences on a forex trader's trades. If the trader isn't up to date about various correlations among currency pairs, then he may experience lower profits, or he might take on further risk.

What is Currency Correlation?

Currency Trading

Currency Correlation means that there is a relationship that can be measured statistically between two financial instruments. With regards to the forex market, it would refer to the relationship between two pairs of currency.

The relationship correlation between these pairs are referred to as positive or negative. They will either move together in a positive direction, or they will move together in a negative and opposing direction.

"Correlation Coefficient" refers to the measure of the correlation. It ranges between -1 and +1. +1 means 100 percent positive correlation. On the other hand, -1 means 100 percent negative correlation.

Examples of a Positive Relationship Correlation

If you look at EUR/USD, and GBP/USD, you will see that these currency pairs have a positive correlation. In fact, they are almost identical, particularly over a long period of time. This means that over a period of time, the correlation between the pairs will be highly positive. This will be more apparent over a long time period, and not necessarily over a short period of say, a few days.

The reason for this is because the Euro (EUR) and the British Pound (GBP) are European currencies. As such, they are based upon the same fundamental principles. So both of these will behave similarly in relation to the U.S. dollar (USD).

Some Basic Guidelines

Here are some general rules for clarification:

The correlation between two currency pairs becomes more significant when viewed over a long period of time. With respect to the Correlation Coefficient, the higher the number either positive or negative, the stronger the degree of correlation. It's key to get a correlation at the 0.9, or 1.0 level, positive or negative. This represents the strongest correlation. If the value is below 0.5, then there really isn't any correlation.

How Is This Important to Forex Trading?

If the trader knows in advance the correlation amongst various currency pairs, then the trader can take better positions and avoid undue risk.

If the trader opens positions in two positively-correlated currency pairs, then he would be doubling his risk. On the other hand, if he were to go with two negatively-correlated currency pairs, his risk would be lowered, but so would the profit margin potential.

In the end, Forex traders do themselves a favor by having knowledge in advance about strong currency correlation pairs.

Why Currency Correlation Is Important in Forex Trading