A currency correlation is a measure of the extent to which two currencies have a statistically significant link in terms of value and the chance that market readjustments would cause their prices to move in the same direction. Forex markets tend to reward traders based to a large extent on their understanding of the nature of relationships between different currencies.
Currency pairs can be positively or negatively connected, or they can have no connection at all. When a pair of currencies and another pair react similarly to market developments, the two are said to have a positive correlation.
Negative correlations, on the other hand, are instances in which one pair responds to market developments in a completely opposite manner to the other. That is, one appreciates while the other declines. Finally, certain pairs are indifferent about changes in the values of the others. As a result, they are termed as having no correlation. Once you grasp how to use this concept, you can realize a substantial change in earnings. Combining this knowledge with the appropriate strategy can also help to reduce risk exposure.
Let’s take an instance whereby an investor purchases two currency pairs with a negative correlation. A good example would be EURUSD and USDJPY. With this kind of setup, gains in one market may be countered by losses in another. This is a risk management strategy that is commonplace among forex investors.
In an alternative scenario, if the trader had bought two pairs of currency that are strongly correlated, they would double their profit potential as well as a loss potential. This is because both pairs would respond to market readjustments in the same manner, whether towards a winning end or a loss-making end.
The coefficient of correlation
The coefficient is a scale that describes the level of convergence or divergence between different currencies based on their historical exchange rates. It is essentially an assessment of the strength of their relationship. It is depicted on a scale of -1.00 to 1.00, with -1.00 being the weakest link and 1 representing the strongest.
A perfect positive correlation refers to one that is rated as coefficient +1. These are pairs that have historically responded in the same manner to changes in market conditions. They will therefore appreciate or depreciate together.
A perfect negative correlation is rated as coefficient -1. These are pairs that have historically responded in the opposite manner to changes in market conditions. Therefore, a rise in one is always followed by the depreciation of the other.
A correlation of about +0.75 exists between the EURUSD exchange rate and the AUDUSD exchange rate, for example. It follows, therefore, that partial market hedging can be achieved by purchasing the EURUSD and selling the AUDUSD.
In the case of the GBPUSD and EURGBP, they have historically had a negative correlation. As a consequence, it is profitable to create a hedge by buying and selling both options. It is possible to earn profit by buying the GBPUSD pair if the pair appreciates, but those gains will be offset by the loss of the long position of EURGBP.
In instances where two pairs have a strong positive correlation, it is a common practice to take cues from the price action of one pair to predict the likely direction of the other. The rule of thumb is to always ensure that you integrate the appropriate technical tools in your analysis. An example would be the use of support and resistance levels in our analysis. If one of the perfectly correlated pairs breaches these levels, you can anticipate a breakout by the other pair.
However, the forex market is full of surprises, and there are always exceptions to rules. Market forces do not always align with idealistic trading rules. In some instances, even the perfectly related pairs may divert from each other. Under such a circumstance, you should be alive to the reality on the market and go long on one while selling the other.
The approach is predicated on the assumption that the price movements of the two currency pairs will converge once again in the near future. In this instance, we have a non-directional arbitrage since the pair prices reflect several currencies’ relative values.
Remember that there are no guarantees in the market, and you should always watch out for changing circumstances and adjust accordingly. There is no fool-proof approach to profiting in forex. A careful setup strategy can, for example, be rendered meaningless by geopolitical changes such as the imposition of trade barriers or the raising of trade tariffs.
The degree of correlation between currencies has an impact on how they fluctuate in the foreign exchange market. Traders can leverage this and increase their profit margins if they implement appropriate strategies, as discussed above.
However, as mentioned above, the market is not restricted by trading strategies, but ultimately, prices are determined by the forces of demand and supply. Therefore be flexible enough to appreciate when a particular approach is out of sync with real market conditions.