How to use currency correlations to lower risk
Currency correlation is not the most important element in Forex trading, however, knowing how to use currency correlation to your advantage will lower overall risk and exposure long term.
Currency correlation in the Forex spectrum indicates the analytical measure of each connection between two currencies. Basic currency correlation analysis will range from -1.0 to +1.0.
A correlation of +1.0 means those two currencies will move in the same direction 100% of the time. A currency correlation of -1.0 implies the two currencies will move in the opposite direction 100% of the time. A currency correlation of 0 means that the currency pairs are mostly irregular, sometimes neutral, and always uncorrelated.
The correlation of each of the currency pairs is familiar to most traders. The pound and the US dollar are correlated, so the GBP/AUD and EUR/GBP pairs are affected by the fluctuations of the US dollar.
Broadening risk exposure across different pairs
Some Forex traders might see strength in an index and trade Forex pairs that include that index currency.
This is a basic tactic. For example, the EUR/USD and AUD/USD are not interdependent 100% all the time. In this case, Forex traders can trade within these currencies and distribute their amount of risk. Sometimes the flawed correlation among the two different currency pairs allows for more diversification and a much lower risk overall.
Do correlations in Forex change?
Forex currency correlations will change frequently. When these changes occur, it is important to take any shifts into account when managing open trades. Many factors cause price influxes to work against currency correlation.
Index levels, fundamental and global economic factors can all influence a specific currency value and impact its relationship with another currency. You will see negative currency correlations happen within the short term on positively interdependent currencies, whether or not you are holding long-term trades.
Should you always trade based on currency correlations?
The short answer is no. It is vital to treat each chart breakdown separately when it involves medium/long term bias. On the other hand, do not purposely trade against correlations when trying to gain returns with strategies.
Understand correlational behaviour for a selected currency pair and use it as a confluence for currency strength or weakness. You should be able to find some highly profitable trades when you know the times at which currency correlation will wipe out positions.
Currency correlations conclusions
Overall, to be a well-rounded Forex trader, you should know your exposure when managing different currency pairs as values fluctuate. By recognising patterns and trading what you see, you may gain more meaningful experience when trading a select few pairs. With this learning strategy, you know for which common traits to seek on a technical and fundamental level.
It is vital to keep this currency correlation concept in your mind when viewing the bigger picture. Regardless of your Forex trading plan and whether you are looking to broaden your Forex trading watchlist, it is vital to find other pairs to leverage your investments in the Forex market.