I am sure you would have noticed that some pairs seem to move together and create very similar patterns.
For example; if one JPY pair creates a certain move, then a lot of them will, or if one USD pair sells off heavily, many of them will.
This is correlation and what we look at in this lesson.
What is Correlation
Correlation is the connection or relationship between two or more mutual things.
A basic example of correlation and how it applies to what we are using it for may be apples and oranges and their respective prices. If the price of apples goes up and the price of oranges also goes up at the same time, they would have a positive correlation.
If the price of apples rises, but the price of oranges falls at the same time this would be an inverse or negative correlation.
Positive and Negative Currency Correlation in the Forex Market
There are stronger amounts of correlation and in the financial world understanding how strong or negatively one market is correlated to another is crucial.
You do not want to be over risking in many markets that are highly correlated and putting yourself at risk if they all fail at the same time.
When we are looking at correlation in the Forex markets we are looking to see how closely two or more pairs move together.
The example of this was given above with the JPY pairs, but there are many correlation instances that do not involve the same currency.
Positive and Negative Correlation
Correlation is a statistical measure.
The scale for correlation and how closely two markets are correlated starts as +1. This is known as a positive correlation or a coefficient correlation.
A reading of -1 indicates an inverse or negative correlation, meaning as one market moves higher, another moves lower.
The more positive or negative the correlation reading, the more highly correlated those two markets are.
It is important to remember that unlike the stock market or other trading products, the Forex market trade in pairs. This will mean correlation rates are regularly changing as each individual currency changes.
What Forex Pairs are Correlated?
With the world coming closer together day by day, the most observed correlation in the Forex markets is by region.
The reasoning behind this is simple; if one region has a large downfall or sudden increase, it will affect the others in the region.
Because currencies are traded in pairs another simple, but incredibly effective correlation risk management tool is never entering more than one trade in the same currency.
For example; a trader mindful of correlation might choose to only take a trade in one Euro position such as the EURUSD and not increase risk with further Euro positions such as the EURAUD or EURCAD. This way if the Euro turns they lose one trade and not two or three.
As we mentioned above, there are also other strong positive and negative correlations in the Forex markets.
You can use a super handy correlation calculator at investing to see-up-to date correlation amounts.
You can also checkout the myfxbook market correlation graph that shows all the Forex pairs and how they are correlating in real-time.
Lastly
When we risk too much on any one trade, or multiple trades we very quickly run the risk of either putting a large dent in our account, or blowing it all together.
Knowing how correlation works, how we can manage our risk so we are not risking too much on any currency pair or region can help us limit the downside.
Below I have included a video showing how you can enter similar Forex pairs without risking too much capital, or risking too much of your account.
