What Is Risk Management? Drawdown and Maximum Drawdown, Reward-to-Risk Ratio
Leverage and Margin Details Overview You Need to Know While Trading
Position Sizing Details Overview and How to Calculate Position Sizes
What is Stop Loss? 4 Types of Stop Losses, Rules and Mistakes on Stop Loss
Scaling In and Out of Positions Full Overview
Currency Correlations Explained, Factoring in Currency, Calculate Currency Correlations
Currency Correlations Explained, Factoring in Currency, Calculate Currency Correlations
Currency Correlations Explained, Factoring in Currency, Calculate Currency Correlations
The rule of the market is that when one currency pair falls, the other one rises. However, there are also chances that when one currency pair falls, another one falls also copying the trend. If you have witnessed this trend, this is what currency correlation is.
The currency correlation is the statistical measure of how two currencies move in relation to each other. Thus, this relation tells us in which direction the two currency pairs will move in the given period of time.
Currencies are traded in pairs. There is a base currency and a quote currency. Unless you are planning to trade just one pair, it is mandatory that you learn and understand how currency pairs move in relation to one another. Currency correlations can greatly impact the amount of risk you are exposing your trading account to.
Correlation is calculated into a correlation coefficient that ranges between -1 and +1. A perfect positive correlation indicates that two currency pairs will move in the same direction all the time. A perfect negative correlation indicates that two currency pairs will move in the opposite direction all the time. Zero correlation means that the movement between the two currency pairs will have no correlation and they will have independent movement.
How To Read Currency Correlation Tables
Reading currency correlation tables is not that difficult. Don’t believe us? Have a look at the following tables. Each table shows the relationship between the main currency pair and other currency pairs in different time zones or frames.
What you need to memorize is that currency correlation is represented in decimal format by a correlation coefficient, simply a number between -1.00 and +1.00. We have discussed the positive and negative signs on these numbers in our previous lessons.
+1 coefficient suggests that the two pairs will have a strong positive correlation and they are highly likely to move in the same direction. Similarly, -1 coefficient suggests that the two pairs still have a strong negative correlation and they are more likely to move in the opposite directions. A coefficient near or at zero indicates a very weak or random relationship. This type of relationship means that the currencies will not move in the same or opposite directions but random movements will be seen.
Are You Doubling Your Risk Without Knowing It?
When you are trading different cash pairs in your trading account at full throttle, you should take all the steps to ensure that you know your RISK EXPOSURE very well. Let’s assume, in most cases, trading AUD/USD and NZD/USD are basically similar to having two indistinguishable trades open since they, as a rule, have a positive connection.
You may accept that you’re spreading or broadening your risk by trading in various sets, however numerous sets will in general move a similar way. So as opposed to decreasing risk, you are amplifying your risk! Accidentally, you are really presenting yourself to MORE risk.
This is known as overexposure. We should take a gander at a precedent including two exceedingly corresponded combines inside a multi-week time span: the EUR/USD and GBP/USD.
Cash Correlation Example #1: EUR/USD and GBP/USD
To demonstrate to you that the numbers don’t lie, here are their 4-hour graphs. Notice how the two of them moved a similar way. Coming back to the subject of risk, we can see that opening a situation in both the EUR/USD and the GBP/USD is equivalent to getting serious about a position.
For instance, on the off chance that you purchased 1 part of EUR/USD and purchased 1 parcel of GBP/USD, you’re essentially purchasing 2 loads of EUR/USD, in light of the fact that both the EUR/USD and GBP/USD would move a similar way in any case.
At the end of the day, you are INCREASING your risk. In the event that you purchase EUR/USD and GBP/USD, you don’t persuade two opportunities to not be right! All you get it is one shot provided that EUR/USD falls and you get stopped out, GBP/USD will no doubt fall and stop you out likewise (or the other way around).
You likewise wouldn’t have any desire to purchase EUR/USD and sell GBP/USD in the meantime in such a case that EUR/USD skyrockets, at that point GBP/USD would most likely skyrocket additionally and where does this leave you?
In the event that you figure your benefit or misfortune will dependably be zero, at that point you’re off-base. EUR/USD and GBP/USD have diverse pip esteems and on the grounds that they exceptionally correspond doesn’t mean they generally move in the equivalent definite pip run.
Volatility inside money sets is flighty.
EUR/USD can soar 200 pips, while GBP/USD just goes up 190 pips. In the event that this occurs, the misfortunes from your GBP/USD trade (since you were short), will eat up most, if not all, of the increases from your EUR/USD trade.
Presently how about we envision that EUR/USD was the pair that climbed 190 pips, and GBP/USD had the greater move of 200 pips. You would’ve certainly had a LOSS! Going long one cash pair and going short another money pair that are exceptionally corresponded is amazingly counterproductive. More than paying for the spread twice, you should limit your increase since one set eat into the other pair’s benefits. What’s more, far more terrible, you could finish up losing because of the diverse pip esteems and consistently changing the volatility of cash sets.
Money Correlation Example #2: EUR/USD and USD/CHF
We should investigate another precedent. This time with the EUR/USD and USD/CHF. While we just observed a solid positive correlation with the GBP/USD, the EUR/USD has a negative relationship with the USD/CHF. In the event that we take a gander at its one-week connection, it has an ideal relationship coefficient of – 1.00. It doesn’t get any more inverse than these people!
These two sets absolutely move on the contrary headings. Look at the outlines:
- EUR/USD on a downtrend
- USD/CHF on a downtrend
Taking inverse positions on the two adversely related sets would be like taking a similar position on two profoundly positive connected sets. Purchasing EUR/USD and selling USD/CHF would be equivalent to getting serious about a position.
For instance, on the off chance that you purchased 1 part of EUR/USD and sold 1 parcel of USD/CHF, you’re fundamentally purchasing 2 bunches of EUR/USD, in such a case that EUR/USD goes up, at that point USD/CHF goes down, and you’d profit on the two sets.
It’s imperative to perceive however that you have INCREASED your risk presentation in your trading account on the off chance that you do this. Coming back to the model with you being long EUR/USD and short USD/CHF, if EUR/USD really dropped like a stone, in all probability both of your trades would be stopped out bringing about two misfortunes.
You could’ve limited your misfortune by basically choosing to go long EUR/USD OR go short USD/CHF, rather doing both. Then again, purchasing (or selling) both EUR/USD and USD/CHF in the meantime is typically counterproductive since you’re essentially counteracting each trade.
Since the two sets move in inverse ways like they detest each other’s guts, one side will profit, yet the other will lose cash. So you either end up with little addition since one set eats into the other pair’s benefits. Or on the other hand, you could basically finish up with misfortune because of each pair’s distinctive pip esteems and volatility ranges.
5 Reasons Why Factoring In Currency Correlations Help You Trade Better
Currency correlation, as discussed earlier, help us know whether the two currency pairs will move in the same, opposite, or completely random direction over a given period of time. It is always important to remember that currencies are traded in pairs and no single currency pair is totally isolated.
Correlation is computed into a correlation coefficient that ranges between -1 and +1. Let’s give you a guide to interpreting the different correlation coefficient values.
|-0.1||Perfect Inverse Correlation|
|-0.8||Very Strong Inverse Correlation|
|-0.6||Strong Inverse Correlation|
|-0.4||Moderate Inverse Correlation|
|-0.2||Weal Inverse Correlation|
|0||Random or Zero Correlation|
|0.2||Weak Insignificant Correlation|
|0.4||Weak Low Correlation|
|0.8||Strong High Correlation|
Now you are well prepared to read the currency correlation through a fancy chart. We know how much you are interested in knowing how currency correlations can make your trading more successful. Here are a few reasons why you need this skill in your arsenal.
Get Rid of Counterproductive Trading
Using correlations help you avoid positions that cancel out each other. Operating a position long in relation to a long other pair is not only pointless but expensive at times as well. Moreover, paying for the spread for the second time will make one movement in the price up for one pair and down for the other one.
Leverage Profits and Losses
You have the opportunity to maximize on positions to make maximum profits. Here, let’s have a look at the 1-week EUR/USD and GBP/USD relationship from the example discussed in the previous lesson.
These two pairs have a strong positive correlation with GBP/USD just behind EUR/USD. Opening a long position for each pair is simply like taking EUR/USD and increasing your position in the market for the given period of time.
In this case, you are simply making use of leverage! If things go right, you will be making more profit and vice versa.
Understanding that relationships exist likewise enables you to utilize diverse money sets, yet at the same time influence your perspective. As opposed to trading a single currency pair constantly, what you can do is spread your risk over the two currency sets that move in a similar direction.
Or, you can also choose pairs that have a strong correlation (around 0.7). Let’s suppose, EUR/USD and GBP/USD will in general move together. The weak connection between these two currency pairs provides you the chance to expand which diminishes your risk. Suppose you’re bullish on USD.
Rather than opening two short places of EUR/USD, you could short one EUR/USD and short on GBP/USD which would shield you from some risk and broaden your general position. If the U.S. dollar sells off, the euro may be influenced to a lesser degree than the pound.
Despite the fact that supporting can bring about acknowledging littler benefits, it can offset the misfortunes. On the off chance that you open a long EUR/USD position and it begins to conflict with you, open a little long position in a couple that moves in the opposite direction EUR/USD, for example, USD/CHF.
You can exploit the distinctive pip esteems for every currency pair. For instance, while EUR/USD and USD/CHF have a practically flawless – 1.0 inverse relationship, their pip esteems are extraordinary. If you have any confusions regarding the movement of the currency pairs,
Accepting you trade a 10,000 small scale parcel, one pip for EUR/USD rises to $1 and one pip for USD/CHF rises to $0.93. In the event that you get one scaled-down part EUR/USD, you can HEDGE your trade by getting one smaller than expected parcel of USD/CHF. On the off chance that EUR/USD falls 10 pips, you would be down $10. In any case, your USD/CHF trade would be up to $9.30.
Rather than being down $10, presently you’re just down $0.70! Despite the fact that supporting sounds like the best thing since cut bread, it has a few hindrances. In the event that EUR/USD energizes, your benefit is constrained on account of the misfortunes from your USD/CHF position. Additionally, the relationship can weaken whenever. Envision if EUR/USD falls 10 pips, and USD/CHF just goes up 5 pips, remains level, or falls too!
Currency correlations can be used to confirm your trade entry or exit signals.
For example, the standard EUR/USD appears to be testing a crucial support level. You are looking at the price action and looking to sell on a breakout.
As you know that EUR/USD is in strong correlation with GBP/USD and negatively correlated with USD/CF and USD/JPY. What you need to see is that if the other pairs are moving in the same direction as EUR/USD as well.
What you should know that prices may actually trade under the support level and you have been observing it as well simply because the other three pairs are trading in proportion with EUR/USD.
If you are still keen to trade this setup, you should play it safe and trade with a smaller position to keep the risk minimum.
Be Careful! Currency Correlations Change!
Currency correlations between currency pairs can be strong or weak and it may continue for days, weeks, months, or even years. However, they eventually change with time and often at times change when it is not even expected.
What you see this month may not be the case next month.
Let’s consider the table below:
Comparing you coefficients for a given pair in different time frames, what do you notice the most?
Yes, they are changing across the board in all the directions. Because of the constant shifts in the market, you should be aware of currency correlation coefficients.
Coming to the above table, over a one week period, the correlation between USD/JPY and USD/CHF was 0.22. This is quite a low correlation coefficient and indicates that the pairs have an irrelevant correlation. However, if we look at the three-month data for the same time period of the same currency pairs, it is clear that the number increases to 0.52 and then to 0.78 for six months and then to 0.74 for the year.
In this same example discussed above, you can see that these two pairs had a “separation” in their long haul correlation relationship. On the off chance that they were a genuine couple and had just dated a month or less, they would’ve thought they were contradictory.
Much to their dismay, the energy will begin warming up later! In the event that you take a gander at EUR/USD and GBP/USD, here’s a case of the degree to which currency correlations can change and hop around. The one-week time frame demonstrates a solid correlation with a 0.94 coefficient!
But this relationship seriously falls apart in the one-month time frame, dropping to 0.13, before improving again for its three-month duration to a strong 0.83, at that point decaying again to a feeble correlation in its half-year trailing period. The reasons for currency correlations to change vary for a lot of reasons including a change in interest rates, shifting monetary policies, and the collection of economic or political events.
How To Calculate Currency Correlations With Excel
Calculating currency correlations is as easy as operating Microsoft Excel.
Let’s discuss how you can do that!
It is obvious that you won’t be creating the daily price data but gets it online from different sources like the Federal Reserve.
- Copy and paste your data into an empty spreadsheet or open the exported data file from Step 1. Get the data for the last six months.
- Organize the data as per the time frame for all the currency pairs.
- Choose your time frame for which you want to calculate the currency correlation.
- In the first empty cell below your first comparison pair (I’m correlating EUR/USD to the other pairs, so I’m starting with EUR/USD and USD/JPY), type: =correl(
- Choose the range of cells for EUR/USD price data and put a comma. Now, you will be surrounding this range by a box.
- Choose the next currency pair’s range using the same method as above i.e. USD/JPY.
- Hit the enter button and the formula will calculate the correlation coefficient for EUR/USD and USD/JPY.
- Repeat the steps 5-9 for other currency pairs and other time frames.
And that’s it! Now you can create as many correlation coefficients for as many currency pairs and time frames as you want. However, you will have to keep it updated manually.
Some currency pairs move in parallel with each other. And similarly, there are some currency pairs that completely move in the opposite directions. When you are trading multiple currency pairs in your trading account at the same time, you are increasing the risk.
You may think that spreading or diversifying your risk by trading in different pairs but a lot of them can move in the same direction. In this case, you are just magnifying your risk. Correlations between pairs can be weak or strong and may last for days, weeks, or even years. What you need to know that they can change. Keeping up with the currency correlations can enable you to settle on better choices in the event that you need to use, support or broaden your trades.
What you need to remember
Coefficients are calculated using the closing prices of the day. Positive correlations denote that the currencies are moving in the same direction. Negative correlations denote that the pairs are moving in the opposite direction. Zero correlation suggests that the currencies are moving in random directions.
Currency pairs that move in the Same Direction
- EUR/USD and GBP/USD
- EUR/USD and AUD/USD
- EUR/USD and NZD/USD
- USD/CHF and USD/JPY
- AUD/USD and NZD/USD
Currency pairs that move in the Opposite Direction
- EUR/USD and USD/CHF
- GBP/USD and USD/JPY
- USD/CAD and AUD/USD
- USD/JPY and AUD/USD
- GBP/USD and USD/CHF
When you want to trade pairs that are highly correlated, you can go for both the setups. Just remember all your risk management rules.