Correlation is a measure of the similarity of two currency pair charts. If every time one chart moves up or down the other chart moves by a similar amount in the same direction we say that one chart is highly correlated to the other. Essentially if you put the charts side by side there are few if any differences. The correlation value in this case would be 1.
The Risks and Value in Forex Correlation
You can also have the case where when one chart moves in an equal but opposite direction to the other. In this case one chart is a mirror image of the other and we say that the charts are negatively correlated and have a correlation value of -1. In between these two extremes we have every conceivable combination of correlation. A correlation of 0 means no correlation at all.
Now you understand what Forex correlation is; why is it important?
The main reason we use forex correlation is to do with the control of risk. The effective management of risk is probably the single most important factor in determining your trading success. You probably have a rule in your trading plan (you do have one don’t you!!!) that says do not risk more than say 2% of your trading capital in any one trade. By doing so you limit the potential impact if a trade goes against you, preserving your hard won trading capital.
Some currency pairs are very highly correlated. For example, the strength of the Swiss Franc against the Euro has caused Switzerland some significant social and economic problems in recent times. As a consequence the Swiss National Bank has been holding the value of the Franc at around 0.8 Euros since the beginning of 2012. Approximately 40% of the Swiss GDP is allocated for this purpose! What does this mean for Forex?
Forex Correlation Example:
Have a look at the following chart comparing the USDCHF vs EURUSD.
As you can see in the diagram above, these two forex correlation pairs are almost perfectly negatively correlated. If you were to open a buy order on the EURUSD with a 2% risk and open a sell order with the same risk on the USDCHF then this would be exactly the same as opening a single buy order with a 4% risk on the EURUSD, hence breaking your maximum risk rule.
If one trade goes against you then it is almost certain that both would. If we have multiple correlated pairs amongst those we trade, then it follows that the potential for exposing our accounts to excessive risk is considerable.
Knowing that two currency pairs are highly correlated can be useful in a number of ways.
Firstly we can avoid over extending our risk. We can do this by either:
1. Avoiding trading two or more correlated pairs at the same time, stick to one out of the set.
2. Spread the risk by taking a smaller position on trades across correlated groups. For example, if we know that two pairs are highly correlated, then only take a 1% risk on each, thus ensuring the overall risk does not exceed our maximum.
3. Only take a trade if all open trades on any correlated pairs have zero risk (ie; stoploss is at or beyond the trade entry price)
Secondly, being aware of highly correlated pairs can be helpful in confirming or giving early warning of trading signals. If the correlation isn’t perfect (ie; 100%), then a trade signal on one pair often occurs before the corresponding signal on the other.
In summary, for the uninformed, correlations are a trap that can potentially wreck their trading; for the informed trader however they hold no fears and can potentially enhance trading.
Correlations vary over time and tend to be different over different time frames. The correlation between USDCHF and EURUSD is obvious and well known. However, there are many more significant correlations between commonly traded currency pairs that are not so apparent.
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