Currency correlation in forex trading

Financial markets rarely operate independently. Movements in one asset often influence others, leading to situations where some prices rise while others fall.

This phenomenon is known as market correlation. While it can be useful for identifying trading opportunities, it may also increase risk if not handled carefully. However, understanding the principles of correlation in the forex market can help you effectively reduce overall risk.

Key Topics:

1. What is market correlation?

2. Types of correlations

3. Example of currency correlation

4. Currency pairs with high correlation

5. Importance of correlations in trading

6. Commodity correlations

7. Relationship between currencies and stocks

8. Practical tips for trading with currency correlation

This overview provides the foundation for understanding how correlations work and how to use them effectively in trading.

What is market correlation?

Market correlation measures the extent to which the movements of different assets influence one another. It can refer to specific markets, sectors, or entire asset classes. However, it’s important to note that correlations are not fixed and may change over time.

Correlation in percentages:

• 100% correlation: Represents a perfect correlation where two markets always move in the same direction. If one market rises, the other follows.

• 50% correlation: Indicates that the markets generally move in the same direction, but their movements are not always perfectly aligned.

Types of correlations

Correlations can be categorized into three types:

1. Positive correlation: Two markets move in the same direction. If one rises, the other also rises.

2. Negative correlation: Market movements are opposite. When one rises, the other falls.

3. No correlation: There is no significant relationship between the movements of the two markets; they are independent.

Understanding these correlations is key to effective risk management and optimizing trading strategies.

Measuring correlations

Correlations are expressed on a scale from -100% to 100% and fall into five main categories:

• -60% to -100% – Strong negative correlation:
  Two markets move in opposite directions. If one rises, the other falls.

• -20% to -60% – Moderate negative correlation:
  Markets tend to move oppositely, but not always in perfect synchronization.

• -20% to 20% – Essentially uncorrelated:
  There is no meaningful relationship between the movements of the two markets.

• 20% to 60% – Moderate positive correlation:
  Markets generally move in the same direction, though not perfectly aligned.

• 60% to 100% – Strong positive correlation:
  The movements of the two markets are very similar. If one rises, the other usually follows.

This framework helps traders and investors better understand relationships between assets and utilize correlations when planning strategies.

Example of currency correlation

Current correlation coefficients for the EUR/USD pair with other major currency pairs may vary depending on the time frame and market conditions. Precise and up-to-date data on these correlations can be obtained through specialized financial platforms or analytical tools offering real-time statistics and charts.

For example, the National Bank of Slovakia provides exchange rate charts that can serve as a foundation for analyzing correlations between different currency pairs. For more detailed analysis and precise correlation coefficients, it is advisable to use specialized analytical tools or platforms providing such data in real time.

These data suggest that EUR/USD has a strong positive correlation with GBP/USD, meaning they often move in the same direction. Conversely, EUR/USD has a strong negative correlation with USD/CHF, indicating they move in opposite directions. The correlation with USD/JPY is weaker and negative, meaning their movements are less closely related.

You can find up-to-date correlation data on platforms like Myfxbook.com.
Note: Correlation coefficients may change over time depending on market conditions. Regularly monitoring current data is essential.

Currency pairs with high correlation

Highly correlated currency pairs include EUR/USD and GBP/USD due to close economic and geographic ties between the eurozone and the United Kingdom. This connection is further supported by the fact that both pairs share USD as the counter currency, meaning any change in the dollar affects both pairs simultaneously.

Examples of correlated pairs

• EUR/USD and GBP/USD: These pairs often move in sync due to the regions’ proximity and economic cooperation.

• EUR/USD and AUD/USD: The Australian dollar tends to correlate with EUR/USD, mainly due to global market trends and trade relationships.

• EUR/USD and NZD/USD: The New Zealand dollar shows a similar correlation with EUR/USD, as both pairs are influenced by USD movements and broader market conditions.

Why These Pairs Correlate:

1. Economic links: The eurozone and the UK are closely connected through trade and economic ties.

2. Counter currency USD: All listed pairs have USD as the counter currency, so any strengthening or weakening of the dollar impacts all pairs similarly.

3. Global market factors: Risk sentiment on global markets often influences currencies like AUD and NZD similarly to EUR, resulting in comparable movements.

Importance of correlations in trading

Correlations significantly affect your overall risk and final outcomes. Their impact can be negative, primarily because they disrupt portfolio diversification. If markets are strongly correlated, movements in one can influence your entire portfolio.

Risks associated with correlations:

• Example: If you hold short positions in two markets with a 75% positive correlation, a bearish trend in one will likely result in a similar decline in the other. This increases the risk of losing capital on both positions simultaneously.

• Increased portfolio risk: Holding multiple correlated positions can result in much higher risk than it may initially seem, as movements in one market affect others.

How to mitigate correlation risks:

• Analyze markets that correlate with one another.

• Identify markets that can enhance portfolio diversification.

• Pay attention to volatility, which can amplify correlations and increase overall risk.

Profiting from correlations

Correlations can also be leveraged for profitable trading:

• Arbitrage strategy: When trading stocks or forex, look for correlated markets. If one market deviates from the norm, you can anticipate its return to standard levels and take a suitable trading position.

• Forex example: If EUR/USD and GBP/USD have a strong positive correlation, you can trade with the expectation that movements in one pair will mirror those in the other.

Volatility and correlations

In times of high volatility, markets tend to correlate more strongly, which can:

1. Increase your overall risk.

2. Challenge portfolio diversification.

Careful monitoring of correlations and volatility is crucial for effective risk management and taking advantage of trading opportunities.

Commodity correlations

Some market correlations are short-term, while others persist for years and show stability. However, it’s important to remember that lasting correlation between two assets is never guaranteed. Here are a few well-known examples useful for trading:

1. USD and Gold:

One of the most well-known correlations is between the US dollar and gold. As gold is priced in dollars, its value often depends on the strength of the currency. A stronger dollar tends to push gold prices down, creating a significant negative correlation.

2. AUD/USD and Copper:

Certain currencies are closely tied to specific commodities. For instance, the Australian dollar (AUD) is closely linked to copper prices, as Australia is a major exporter of metals. The value of AUD/USD often mirrors movements in copper prices.

3. USD/NOK and Brent Crude Oil:

USD/NOK has an inverse relationship with Brent crude oil prices. Norway, as one of the leading oil exporters, relies heavily on its oil revenue—Brent crude accounted for a significant portion of its GDP.

Relationship between currencies and stocks

The correlation between currency pairs and stock markets reveals interesting interconnections. While this relationship can be complex, certain trends are observable:

• UK example: A declining British pound often leads to a rise in the FTSE 100 index. This is because many companies in the index generate significant revenue in dollars. When these revenues are converted back into a weaker pound, their value increases.

• US example: A weaker US dollar increases export earnings when converted to dollars, while a stronger dollar reduces the competitiveness of US companies’ international profits, potentially impacting stock performance negatively.

Trade and export context

Companies more dependent on exports can benefit from a weaker currency, while expensive imports can negatively affect their costs. It is crucial to analyze a company’s business model and geographic revenue distribution when assessing such impacts.

This comprehensive overview of correlations between currencies, commodities, and stock markets provides a deeper understanding of these relationships, which can be instrumental in making better trading decisions.

Imports and exports – a broader context

Companies heavily reliant on exports can benefit from a weaker currency, as their products become more competitively priced on the global market. Conversely, higher import costs due to a weaker currency can negatively impact their expenses. Therefore, when analyzing companies, it is essential to examine their business models and geographical distribution of revenue.

This overview of correlations between currencies, commodities, and stock markets provides deeper insights into their interrelationships, which can support more effective trading decisions.

Currency correlation: Practical tips for trading

Correlations between currency pairs can fluctuate over time, making it vital to analyze them over both short-term and long-term periods. Using correlation coefficient indicators available on trading platforms like FOREX.com can help you better understand the current relationships between markets.

Trading with currency correlation: Practical tips

Current state of correlation:

• Determine whether markets are currently correlated and assess the strength of this relationship.

• Monitor whether one market influences another, and if price deviations occur, wait for the alignment to stabilize.

Example: If one market reaches new highs while another remains range-bound, it might be wiser to wait until the correlation stabilizes before entering a trade.

Inverse correlated markets:

Trading on inversely correlated markets can sometimes result in trades canceling each other out. However, these strategies can be useful for hedging against short-term risks.

Example: Combining EUR/USD with USD/CHF can mitigate the impact of adverse movements, as these pairs historically exhibit a negative correlation.

Commodity correlation

Currency pairs like AUD/USD traditionally have a positive correlation with gold prices. As a major exporter of gold, Australia’s currency can be influenced by its gold production capacity and global demand.

Tip: Traders leveraging this correlation should monitor factors affecting gold mining and trends in global demand for gold.

Effective use of correlations in trading

Utilizing correlations effectively requires not only understanding the relationships between markets but also grasping the underlying factors influencing these relationships. Continuously monitor how correlations evolve and adjust your strategies based on prevailing market conditions.