Mark Thomas — Trade On Track
There’s always a buzz around the forex world in regard to correlations between currency pairs and how you can use them to your advantage in your trading. While I haven’t personally downloaded or read any of the “secret” reports on this subject, I thought it might be useful to discuss this topic and to give some examples of how I use currency correlations in my own trading.
A “correlation” is a statistical measure of the relationship between currency pairs. It measures how much or how little a currency pair follows the direction of another currency pair. Currency pairs often move in tandem or in opposite directions to each other, which is quite understandable given the fact that the base currency may often be the same. For instance, the AUD/USD pair has a very high correlation with the EUR/USD pair. Over the past week, the two moved in the same direction 95% of the time. The correlation coefficient is expressed as a number from -1.0 to +1.0. A negative number means that the currency pairs moved in the opposite direction to each other more of the time, while a positive number means they moved in the same direction more of the time. Taking this to the extremes, a correlation coefficient of -1.0 means the two currency pairs moved in opposite directions to each other 100% of the time, while a correlation coefficient of 1.0 means the two currency pairs moved in the same direction to each other 100% of the time.
You can research and monitor the daily closing prices of currency pairs yourself, then calculate the correlations, or you can find a resource that does it for you! One such resource is : http://fxtradeinfocenter.oanda.com/charts_data/fxcorrelations.shtml . Oanda provides a visual tool which lets you quickly see the correlation between currency pairs over the last week, month, all the way up to 2 years. Taking a look at it today reveals that the AUD/USD and NZD/USD closely correlate with the EUR/USD pair (over the last week). This varies over time, but with experience these correlations will become ingrained in you and you’ll be able to make good use of them in your trading.
How do you make use of correlations? There are several ways in which I use the correlations between currency pairs. In general, correlation coefficients are calculated on end-of-day prices, so you would think they may not be very useful for intra-day traders. However, I have found that if currency pairs are closely related over the period of a week or a month, then they will often move in tandem throughout the day too. Here are some ideas for how to use correlations:
- To confirm an entry signal. For example: If I have a trading system that gives me a buy signal on the AUD/USD pair but I am not completely confident, I’ll go to the EUR/USD, NZD/USD or even the GBP/USD to see if a similar setup is possible on those pairs and whether there is little resistance to price moving up. Quite often, there may be an obvious resistance level on the AUD/USD that makes me nervous about buying, but if there is little or no obvious resistance on the correlated pairs – that gives me the confidence to take the signal and enter. If the EUR/USD is able to push upwards quite nicely, then I can be confident the AUD/USD will push up too.
- To avoid false breakouts. I especially like to use this during the European session when there are often false break-outs on the GBP/USD. If it looks like the GBP/USD is making a move and I’m ready to enter a trade, I’ll flick over to the AUD/USD to see if it is moving strongly in the same direction. The AUD/USD is a lot less volatile than the GBP/USD, even though they are often closely correlated. So, quite often the AUD/USD will NOT break-out when the GBP/USD breaks a support or resistance level, which gives me a clue that it is probably a false break-out and to hold off entering that particular trade.
- To diversify your market exposure. If you take a long position in both the AUD/USD and the EUR/USD, then you’re effectively taking the same trade but with double the stake. Keep this in mind when you’re calculating your risk … sticking to a 2% risk level per trade is not a good enough rule, you need to ensure that you don’t risk too much over correlated pairs too. If you have multiple trade setup options, it’s best to diversify your exposure by taking say a EUR/JPY trade with a USD/CAD trade (two pairs that are NOT closely correlated).
- To hedge your trades. This is, in a way, opposite to the above advice, but I have often used it to my advantage. If you have trade entry signals that seem to defy the general correlation rules, then you might actually like to take both those signals. For instance, the EUR/USD pair nearly always moves in the opposite direction to the USD/CHF pair. If my trading system gave me a buy signal on the EUR/USD pair as well as the USD/CHF pair, then I would probably take both entries with confidence. The reason I would be confident is that it’s likely that at worst, the correlation factor would be in play and one trade would win and the other would lose – with a net effect of a small or nil gain. At best, both trades would win.
Even if you only like to trade one currency pair at a time, always consider looking at the correlated currency pairs to see which way they are going and whether or not there’s upcoming support/resistance. Looking at correlated pairs can give you the extra confidence to enter a trade or even to exit a trade at the right time. Knowing the currency correlations can also help you manage your overall risk in the forex markets.
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