i. Correlation is the manner in which the price of one currency moves in relation to the price of another.
ii. Two types - positive correlation and negative correlation.
iii. Correlation coefficient is the measure of correlations and its value will be between +1 and -1.
What is correlation?
In finance, the technical definition of correlation is the behavior of the price of one financial asset in comparison with another financial asset.
Correlation simply means the manner in which the price of one currency pair moves in relation to the price of another currency pair. For instance, let’s consider the currency pairs GBPUSD and EURUSD.
On observing the price charts of these two currency pairs one can observe that the price movements of both currency pairs are quite identical.
If GBPUSD is moving up then EURUSD also moves up, whereas if GBPUSD is moving down then EURUSD also moves down.
It should be noted that this does not mean that EURUSD copies the price movements of GBPUSD. This is just for illustration purposes. We will explore the reasons for correlations further in the blog post.
Correlations are of two types, positive correlation, and negative correlation.
A positive correlation is when the price of the two currency pairs moves in an identical manner and in the same direction.
For example, the currency pairs EURUSD and EURJPY are positively correlated. It means that when the price of EURUSD moves up, the price of EURJPY also moves up and vice versa.
A negative correlation is when the price of the two currency pairs moves in an identical manner but in the opposite direction.
For example, the currency pairs EURUSD and CADUSD are negatively correlated. It means that when the price of EURUSD moves up, the price of CADUSD moves down and vice versa.
What is correlation coefficient?
We know that some currency pairs have some correlation with one another but how do we measure this correlation.
How can we determine how strong or weak this relation is? This is where the correlation coefficient comes into the picture.
The correlation coefficient is a statistical measure of the strength of the relationship between the two currency pairs. The values of the correlation coefficient lie between 1.0 to -1.0.
Currency pairs with maximum positive correlation will have a correlation coefficient of 1.0, while currency pairs with maximum negative correlation will have a correlation coefficient of -1.0.
Values of the correlation coefficient between 1.0 and 0 indicate that the currency pairs are positively correlated but are not completely correlated to each other.
The same is the case with values of the correlation coefficient between 0 and -1.0. It indicates that a negative correlation is present but it is not absolute.
Traders often have a benchmark value to determine the strength of the correlation. Some traders consider a reading above 0.5 and below -0.5 to be strong and values other than that are considered weak.
It all depends on how you use it and most importantly how you backtest it.
The calculation part of the correlation coefficient is a tad bit too complicated and we will not dive into it in this blog post.
An easier method to calculate the correlation of currency pairs is by using the correlation function of excel, =correl(range1,range2).
Using this method, you can find the correlation between prices of any currency pairs and you need is the data of price movements of the respective currency pairs.
Why do correlations occur?
The world that we live in today has never been more global. Anything that happens in one country will have some effect on other countries.
There are several foreign currencies listed on the forex market that represent the numerous countries in the world.
Now, different countries function in different manners. Some countries are in a dominant position in the world economy while some are not.
The major nations of the world literally run the global economy and they contribute the most to it.
There are so many fundamental factors that come into play when it comes to the global economy. These global factors are the main reason for the correlations we notice in the currency pairs.
We know that the institutions and banks are major players in the forex market and they move the markets through their trading activities.
These traders do not trade heavily based on technical patterns or technical indicators. Their analysis is based on fundamental analysis.
They look to track all that’s happening around the world and then they take trade decisions. It is these decisions that they take that cause the correlations.
The institutional players are often said to take hedged positions, which means they do not simply go long or short in a particular currency, but rather they look to offset the risk by taking positions in other currencies.
All that I’ve discussed just plainly explores the reason for correlations among currency pairs. A lot of economics and fundamentals take place behind the scenes and it is all at the global macro level.
We as retail traders need not understand deep economics to take our trades, but we must have an idea of what happens on the macro levels that primarily move the markets.
Correlation trading strategies
With all that I’ve discussed, I hope that you now have an idea about what correlations are. I will now talk about some strategies involving these correlations.
Whenever a trader develops a bias for any particular currency pair, he will look to enter into a long or a short position in that particular currency pair accordingly.
For instance, a trader goes long in EURUSD. Now, the risk that he is exposed to completely depends on how the price of this currency pair moves.
In order to reduce his risk, he would look to open a short position in the GBPUSD pair. EURUSD and GBPUSD are two highly positively correlated currency pairs.
Since these two currency pairs are positively correlated, their prices will move in the same direction.
The trader has opened two opposite trades and price movements in both currency pairs will nullify loss to an extent as it is a hedged position.
Now the question would arise as to how to make a profit. It should be noted that currency pairs are not going to be perfectly correlated to each other.
The price movement of one currency pair will not mirror another’s perfect.
Keeping this in mind, traders can devise strategies so as to take a trade in the direction of their bias while also reducing the risks they are exposed to by hedging the position.
Another strategy that traders use to capitalize on the correlations between currency pairs is to take trades when the currency pairs have deviated away from their correlation.
This is known as pairs trading and is again a market neutral strategy and it is based on a mean reversion principle.
If two currency pairs have been moving in a correlation for a long time and due to some short-term event it deviates from the correlation, there are high chances that it will fall back to the correlation in the future.
This strategy is widely used by traders at institutions and they even apply various mathematical calculations to this.
One drawback of this strategy is that the profit earned is very small, hence a huge capital is required to get a reasonable profit.
Do you look at correlations in trading?
Do you trade strategies that are based on correlations? What kind of strategies do you use? Do let me know.
Share this blog post with others and let them also get introduced to this side of the forex trading world.
Feel free to ask questions or queries in the comments section and I will get back to it at the earliest.