Use currency correlations in your forex trading

Use currency correlations in your forex trading

Correlation is the measure of the relationship between two assets. A correlation of +1 means that their prices move in the same direction, to the same degree, 100% of the time, while a correlation of  -1 means that the assets have a perfect inverse relationship and that they always move in the opposite direction. A correlation of 0 means that there is no correlation between the assets, or that relationship between them is completely random.

In forex trading, all of the major currency pairs have some degree of correlation, because all of them use the USD as one half of the pair. Even crosses correlate, because the values of those pairs are determined by combining a major pair (for example, if you were trading the AUD/JPY, this would be calculated using the AUD/USD and USD/JPY pairs).

Correlation tables

Each of the following tables shows major currency pair correlations to the month of December 2010.

The one month correlation table shows that the strongest positive correlation is between the EUR/USD and GBP/USD at 0.737. This indicates that, over that month, the pairs moved in the same direction nearly 75% of the time. Over six months the correlation was stronger, at 0.859, while over a year it was slightly weaker at 0.781.

In contrast, the AUD/USD and USD/CHF had an inverse relationship. With a correlation of -0.936, they moved in opposite directions almost all of the time. Over six months, the relationship was even stronger, at -0.947, and over twelve months it was -0.890.

What’s interesting, and one of the reasons why correlations need to be constantly monitored, is that some of the correlations can change quite dramatically.

The AUD/USD and NZD/USD correlation is one example – these pairs typically have a positive correlation of 0.9 or higher. Yet, in December 2010, the correlation dropped to 0.286. This could have been due to a number of factors, such as poor economic growth figures released by New Zealand in December, and high commodity prices boosting the Australian dollar.

1 month correlation – December 2010

6 month correlation – July – December 2010

12 month correlation – January – December 2010

Changing correlations

Not only are global economic factors very dynamic, but market sentiment frequently shifts and this results in changing correlations. Some of the most common reasons behind changing correlations are diverging monetary policies, sensitivity to commodity prices, and sensitivity to other economic and political factors, which may result in one currency receiving a boost as a safe haven while another falls in due to risk aversion.

Use currency correlations in your forex trading

Traders can take advantage of currency correlations in a number of ways.

First, they can avoid entering two positions that cancel each other out. We know that the AUD/USD and NZD/USD forex pairs move in the same direction 90% of the time. Consequently, if a trader took a long position on one pair and a short position on another, their profits in one position would be offset by a loss in the other.

Second, traders can diversify their forex holdings by focussing on pairs that don’t have a strong correlation. The USD/CAD and USD/JPY have a positive correlation, but it is not always a strong one, ranging from 0.222 for the year of 2010, to 0.674 over the second half of the year. A trader with a bullish outlook on the USD could go long on each of these pairs, rather than going long on two lots of the USD/CAD. The imperfect correlation increases the diversity of the positions, and may lower risk.

Third, when forex pairs that usually correlate don’t do so, a trader could take advantage of this. If currencies correlate in normal circumstances, we know that something abnormal has happened to break the correlation. By monitoring correlations we can determine which currency is in aberration. I.e.: if the AUD/USD is behaving abnormally but the AUD/USD and NZD/USD correlation is maintained, we know it is likely that the USD is the cause. If the correlation is also broken, the AUD is likely the cause.

We also know that, when circumstances return to normal, the correlation may also return, and traders may be able to prepare trades when indicators signal that circumstances are reverting to their previous state.