Correlation

What is Correlation in Forex?

Correlation is a statistical measure that indicates the relationship between two or more variables. In Forex trading, correlation applies to the statistical relation seen between two or more currency pairs. It signifies how these pairs move about one another over a specific period. Correlation can be positive, negative, or neutral, indicating whether the pairs move in the same direction, in opposite directions, or independently.

On a scale from -1 to +1, -1 represents a perfect negative correlation, +1 represents a perfect positive correlation, and 0 represents no correlation. Another common way to express currency correlations is as a percentage. For example, a correlation of -0.90 can also be expressed as a percentage of -90%.

Correlation is an important concept in Forex trading as it helps traders to understand the relationship between currency pairs, it can help traders to diversify their portfolios and reduce risk.

For example, if a trader has a long position in EUR/USD, which is negatively correlated with USD/JPY, then the trader can consider opening a short position in USD/JPY to hedge the risk.

Types of Correlation

Positive Correlation

Positive correlation refers to the relationship between two currency pairs that move in the same direction.

When one currency pair strengthens, the other pairs also show upward momentum. This correlation can arise due to shared economic ties, geographical proximity, or similar market influences.

For example: A positive correlation exists between EUR/USD and GBP/USD due to their shared denomination in USD. If the USD strengthens, both pairs will decrease in value, and if the USD weakens, both pairs will increase in value.

Negative Correlation

A negative correlation refers to the relationship between two currency pairs that move in opposite directions.

As one pair gains strength, the others weaken. A negative correlation often emerges when one currency's strength is inversely related to another's, perhaps due to divergent economic conditions.

For example: EUR/USD and USD/CHF are negatively correlated because the USD is the quote currency in both pairs. If the USD strengthens, EUR/USD will decrease in value, and USD/CHF will increase in value.

Neutral Correlation

In some cases, currency pairs exhibit minimal or no correlation, moving independently of one another. This neutral correlation indicates that the pairs are influenced by distinct factors.

Benefits of Correlation

Forex traders can use correlation in several ways, such as managing risks and developing trading strategies.

Portfolio Diversification

Traders can diversify their portfolios and reduce exposure to excessive risk. For instance, if two currency pairs are highly positively correlated, taking positions in both pairs may increase risk as losses in one pair are likely to be mirrored in the other.

Hedging Strategies

A positive correlation between two currency pairs may indicate that they are influenced by similar factors, such as economic indicators or geopolitical events. Traders can leverage this information to identify potential trading opportunities or to hedge their positions. Conversely, negative correlation can be exploited to create hedging strategies that protect against adverse market movements.

If a trader has a long position in a currency pair that is negatively correlated with another currency pair, the trader can open a short position in the second pair to hedge the risk.

For example: If a trader has a long position on the EUR/USD pair and a short position on the USD/CHF pair, they can use correlation to offset the risk.

Since the EUR/USD and USD/CHF pairs have a negative correlation, the trader can reduce their risk by hedging the two positions.

Trading Opportunities

Forex correlation can also be used to identify trading opportunities. Traders can look for pairs that have a high positive correlation and trade them in the same direction.

For example: If the AUD/USD and NZD/USD pairs have a positive correlation, a trader can buy both pairs if they believe that the AUD/USD pair will increase in value.

Currency Correlation Chart

By utilizing a Forex correlation table or chart, traders can easily analyze and compare the correlation coefficient between different currency pairs over a specific period. This information is crucial as it allows traders to identify pairs that have a high positive or negative correlation.

To further assist you, check out the Myfxbook Currency Correlation Chart. This reliable and user-friendly tool provides comprehensive insights into currency correlations. You can access it at Forex Correlation | Myfxbook.