Currency Correlation

Submitted by Share Trading on 17 March, 2010 - 16:21

In the currency market sometimes it is found that one currency pair is following the movements of another pair. In forex trading this phenomenon is called the currency correlation- something that many forex traders use to make profit in the currency market. The correlation among two currency pairs will be either positive or negative. Now regardless of what type of currency correlation it is, it will always remain within the range of +1 and -1. If the correlation among two pairs is close to +1 then it means they are positively correlated and if it is close to -1 then they are adversely correlated.

It is found that most traders usually prefer to trade the major currency pairs like EUR/USD, USD/JPY, GBP/USD, AUD/USD, and USD/CHF where US dollar is the common currency. This is why some currency pairs usually displays significant currency correlation in the market. For instance, the USD/CHF and EUR/USD are considered as negatively correlated since these two pairs move towards the opposite direction. On the other hand, the EUR/USD and AUD/USD are usually positively correlated. Means, if one of these pairs rally, the other one will most likely follow it.

Trading Positively Correlated Currency Pairs- Few Things to Keep in Mind

In case of dealing with positively correlated pairs, you need to be aware of the fact that trading them together can turn your trades a bit riskier due to the fact that if a trade with one pair is a losing one, there is a good possibility that the other currency pair will come up with the same kind of outcome. Therefore when it comes to combining positions, having a proper understanding of the currency correlation among the pairs is very much important. For example, going long the EUR/USD and AUD/USD can be considered as leveraging the same position due to the fact that these two pairs are positively correlated. Taking a long position for both these pairs is like being hedged 100 percent because one position nearly cancels out the other one.

However, forex traders who are trading in the market for sometime now usually do not expect the currency pairs to follow the same pattern all the time. Factors like monetary policy, political situation and so on can alter the correlation between two currency pairs. This is why it is not wise to blindly follow currency correlation among the pairs to determine trading strategies without considering other factors.

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