"Wow, has anyone else noticed that when the EUR/USD goes up the USD/CHF goes down?" is a 'Eureka' announcement often made by new traders when they first stumble upon basic correlation. In some respects it's a good sign, it displays awareness.
However, as many forex traders will testify if it's that easy we'd simply wait for one currency to spike and immediately take that perfect -1 negative correlation trade. It'd work for a while, then some funky algorithm at Blackrock would no doubt 'front run' the play taking out all our fun whilst hoovering up all the pips.
Surprisingly correlation is one of the least discussed topics on forums dedicated to forex trading and yet a thorough understanding of its mechanics and relevance should form part of any forex traders toolbox.
Correlation is a measure of the relation between two or more variables. The measurement scales used should be at least interval scales, but other correlation coefficients are available to handle other types of data. Correlation coefficients can range from -1.00 to +1.00. The value of -1.00 represents a perfect negative correlation while a value of +1.00 represents a perfect positive correlation. A value of 0.00 represents a lack of correlation.
Because currencies are priced in pairs, no single pair trades completely independent of the others. Once you are aware of these correlations and how they change, you can use them control your trading portfolio's exposure.
The interdependence of currency pairs is straightforward to understand, here's an example; if you trade Sterling versus yen (GBP/JPY) you are actually trading a derivative of the GBP/USD and USD/JPY pairs; therefore, GBP/JPY must be somewhat correlated to one if not both of these other currency pairs. The interdependence of currencies stems from more than the fact they are traded in pairs. Some currency pairs move in tandem, other currency pairs move in opposite directions, which is often the result of more complex forces.
Correlations change, which makes shadowing the changes in correlations important. Sentiment and global economic factors are increasingly dynamic and often change on a daily basis. Strong correlations today might not be in line with the longer-term correlation between two currency pairs. It's therefore essential to consider the six-month trailing correlation. This provides a more focused perspective on the average six-month relationship between the two currency pairs, which tends to be more accurate. Correlations change for a variety of reasons; diverging monetary policies, a currency pair’s sensitivity to commodity prices, unique economic and political factors. Viewing correlation tables from minutes to weeks is also advisable for a comprehensive viewpoint and understanding.
How can we use correlations to manage our trading exposure, how can we use them to our advantage?
The most obvious answer is correlations can help us to avoid entering two positions that in effect cancel each other out. Knowing that EUR/USD and USD/CHF move in opposite directions nearly 100% of time (the -1 correlation) having trading positions of long EUR/USD and long USD/CHF is in some respects the same as having no position. A correlation table will illustrate that when the EUR/USD rallies, the USD/CHF will experience a sell-off.
Conversely, being long EUR/USD and long AUD/USD or NZD/USD is similar to doubling up on the same position given that the correlations are so strong. However, there may be valid reasons to hold trades of similarly correlated pairs, diversification being one.
The EUR/USD and AUD/USD correlation is not 100% positive, therefore traders can use these two pairs to diversify their risk while still maintaining a directional view. Here's a simple example to follow; if bearish on the USD, instead of buying two lots of the EUR/USD, the trader could buy one lot of the EUR/USD and one lot of the AUD/USD. This 'imperfect' correlation relationship between the two different currency pairs allows for more diversification and a marginally lower risk. It must also be noted that the central banks of Australia (RBA) and Europe (ECB) have very different monetary policies, therefore in the event of a dollar rally, the Australian dollar may be more or less affected than the Euro, or vice versa.
Let's take our correlation discussion a bit deeper by using hedging.
A trader could use different pip values to their advantage. For this example we'll once again use the EUR/USD and USD/CHF. Our correlation tables suggest that they have a near perfect negative correlation, but the value of a pip move in the EUR/USD is $10 for a lot of 100,000 units while the value of a pip move in USD/CHF is $11.02 for the same number of units. Therefore, in theory, traders could use USD/CHF in order to hedge any EUR/USD exposure.
If our trader had one short EUR/USD lot of 100,000 units and one short USD/CHF lot of 100,000 units when the EUR/USD increases by ten pips the trader would be down $100 on the position. But since the USD/CHF moves diametrically opposite to the EUR/USD, the short USD/CHF position should be profitable, in all likelihood moving close to ten pips higher, up $110.2. This could in turn adjust a net profit of the positions into $10.2 instead of -$100. This 'hedge' also means smaller profits in the event of a strong EUR/USD sell-off, but in the worst case scenario, losses become much lower.