Using Correlations in Forex Trading

currency correlation

The concept of currency correlations is a useful tool in the world of Forex trading.

Correlations add an extra level of dimension while trading, which in turn can create an extra edge for a better profit and loss statement.

PRACTICAL USE

This article is focused on explaining how currency correlations can be used in a very practical way. Our goal is not to dive into theory or theoretical models but show how correlations can help solve practical trading-related decisions.

The concept of currency correlations has many practical advantages such as confirming an entry, avoiding false break out, filtering worse setups, identifying which currency is trending, and reviewing crosses for a dynamic view. This article reviews them all one by one.

Before this article dives into explaining how currency correlations can benefit each trader, it would be good to share the links where you can find additional information and back ground with regard to the theory of correlations and how they are calculated:

1) The Quick and Dirty Guide to Modern Portfolio Theory – For Currency Traders – Part 1
2) The Quick and Dirty Guide to Modern Portfolio Theory – For Currency Traders – Part 2

FILTERING OUT & CONFIRMING TRADES

The currency correlation tool can be used as a method to filter out trade setups which have a worse probability versus reward-risk ratio. The process how a trader can utilize the concept and tool is as follows:

a) Trader sees a currency pair which matches their strategy;
b) Trader checks correlation tool to see which currency pair is closely correlated to the pair
c) Trader review the correlated currency pair to analyze whether the trade setup on this pair would have a decent chance of materializing by reviewing Support and Resistance and “wide open space;”
d) If yes, trade setup is confirmed and trade can be taken on original currency pair and/or correlated currency pair;
e) If no, trade setup is filtered out and both pairs are discarded.

Here are some tips to keep in mind when exercising this technique:

1) Keep evaluations of the trades that have been filtered out to maintain statistics of the usefulness of this filter;
2) Choose only 1 currency pair (maximum 2) when comparing the trade setup with a correlated pair. Comparing the setup with more pairs only complicated the process.

correlation chart

TREND CORRELATIONS

Traders are able to distinguish which currency is trending when using the Double Trend Trap (DTT) trend indicators.

The DTT trend indicators show traders in a quick and simple manner if there is a trend taking place in the Forex market (for each currency pair). The trader can take that information and combine it to understand the bigger picture of the market structure. Here is an example:

a) The trader sees a downtrend on the AUDUSD;
b) The trader however does not see a trend on EURUSD;
c) But the trader does an uptrend on the EURAUD and GBPAUD;
d) The trader can conclude that the Australian Dollar is trending, not necessarily the Euro or USD.

By comparing and matching various currency pairs in this manner, traders can understand not only which currency pair is trending but also which currency.

CHOOSING SETUPS

As stated above, the currency correlation concept helps a trader both with filtering out trade setups with worse expectancy and with confirming an entry potential. Correlations can provide their usefulness when deciding which currency pair to trade. If a trader has doubts when choosing from two potential trade setups, there is another technique that can provide extra analysis.

Although technically speaking maybe not part of the correlation concept, the trader can look at the third currency pair to see how that pair is setup with regard to trend, momentum, chart patterns, candle sticks and support and resistance. For instance, if a trader has doubts whether to choose between EURUSD and GBPUSD, the trader can review the EURGBP to see which of the 2 (EURUSD or GBPUSD) has better odds of materializing. Another option could be to split the risk on both the EURUSD and GBPUSD trade setups.

second correlation chart

ADDING TRADES

Currency correlations can also provide risk management benefits when adding trades. The main idea is to avoid adding trades with a high level of correlation as to avoid overexposure.

This is how it can happen:

1) The trader has an open trade in the market like the EURUSD long, for instance;
2) The trader is contemplating taking a new trade with a new currency pair such as GBPUSD long;
3) The trader looks at the correlation table and see that both the EURUSD and GBPUSD are highly correlated;
4) The trader skips the second trade setup to avoid being overexposed.

Remember that taking a trade on pairs that are highly correlated is like taking a trade with double the stake.

Keep it in mind for the risk management side of the trading plan. If you want to avoid higher risk on similar setups, then the solution is to diversify the exposure by taking a trade on a currency pair that is not correlated (more than -0.7 and less than +0.7 for instance; read more here about the correlation values)

This article showed 4 practical methods of using currency correlations in real life day to day trading.

Are there other methods that you would like to share with us?

Have you actively been using any of the above methods?

Which method would you like to try after reading this article?

All feedback is welcome! The more a person engages, the easier it is to learn so we always highly encourage leaving a comment with your feedback. That way not only you learn quicker, but other readers gain more insight as well.

Thank you for taking the time to read this and for sharing it.

Wish you a grand weekend and Happy Trading!

 

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