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Currency Correlations – Why They Matter?

 

There are some currency pairs that trade in an interconnected way with other currency pairs. This may have come to your attention whilst you trade, or it may not have. Either way the information here should help you understand that link between the currency pairs and why this is important for your trading.

There are some currency pairs which trade in a similar way each other. For example, when one pair goes up so does the other pair, sometimes in an almost identical way. Additionally, there are some pairs which trade inversely to each other. So as one pair increases, the other pair decreases and again this could be in an almost perfectly inverse relationship.

This relationship between two pairs is known as the currency correlation. The pairs can move in the same direction, in opposite directions or in a random way to each other. The relationships between different currency pairs become important when you trade more than one pair. If you just trade one pair at any given time, then its correlation with other pairs is irrelevant. However, if you trade multiple pairs at a time you could be unknowingly, significantly increasing the risk on your account.

Currency correlation coefficient

This figure tells us how correlated two currency pairs are. The scale can run from -1 to 1 or -100 to 100.

1 or 100 means the two currency pairs are perfectly correlated. The movement between the two pairs will be identical. If you pull up the charts of two pairs which are perfectly correlated, the charts would be identical.

-1 or -100 means that the pairs are perfectly inversely correlated. So, the pairs move in exactly the opposite direction, as one pair increases the other decreases by exactly the same amount.

0 means that there is absolutely no correlation between the two pairs; they move completely at random compared to the other.

Currency correlation data can be found on a currency correlation coefficient table, given for various time frames. MT4 also has a tool providing correlation coefficients.

Example

EUR/USD and GBP/USD has a currency coefficient over 1 week of 0.94. This means that the two pairs are very closely correlated. You would expect to see the EUR/USD chart and the GBP/USD chart look very similar with such a high coefficient.

So, if you went long EUR/USD and then went long GBP/USD you would be doubling up on your risk. This would be the same as doubling your stake in EUR/USD, not something you probably would do intentionally.

IF you go long EUR/USD and short GBP/USD you are paying the spread twice whilst almost netting out to 0 – although not quite.

Alternatively, EUR/USD and USD/CHF have a currency coefficient of -1. If you buy EUR/USD and sell USD/CHF, you would be effectively doubling up on your trade and therefore doubling the risk on your account. Alternatively buying both pairs or selling both pairs at the same time would be a costly waste of time.

By trading currencies with coefficients closer to 0 than 1 or -1 you will be diversifying the risk on your account.

More information

Vantage FX provides its clients further information on how to access and use the MT4 correlation matrix, in the educational centre on their website.

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