/ Currency Correlation in Forex: How to use the approach for successful trading?

In the Forex market, the two main disciplines of financial trading are technical and fundamental analysis. Most traders choose one or a combination of these two approaches to make money from currency speculation. However, there are other approaches that can complement and maximise your profits, one such is currency correlation. This discipline is related to risk management and can provide a better understanding of the market. With currency correlation, you can avoid common problems such as over-trading and wasting capital on unprofitable currencies. We'll explain to you what this approach is all about and how it can help you make more money in Forex.

Currency Correlation

Currencies of different countries are not completely autonomous and can have similar (or negative) reactions to the same factors. Take the GBP/JPY currency pair for example. In this case, sterling is traded against the yen. However, it should be noted that this instrument is actually a derivative of the GBP/USD and USD/JPY pairs. Thus, Sterling, Yen and USD are correlated with each other.

Correlation is the relationship between two variables, which is measured from +1 to -1. If two variables behave similarly under the influence of the same factors (e.g. two currencies that rise in value because of the same economic event), the correlation will be +1 (positive). On the other hand, if one variable behaves completely differently from the other, the correlation will be negative or -1. It is worth noting that correlation can be zero, which means that the two variables are completely independent.

The world is a changing place, and it is possible that currency correlations can also change over time. Two currencies that are moving in the same direction today, in the near future, may already be moving in opposite directions. This is due to various phenomena such as changes in monetary policy, the sensitivity of currencies to commodities or geopolitical events. For this reason, it is very important to measure this factor. Long-term correlations are much more reliable than short-term correlations, in addition, correlations do not persist over all time horizons; it is possible that there is a positive correlation in the short term and a negative correlation in the long term.

How do I calculate currency correlation?

Calculating currency correlation may seem like a long and complicated process, but it is actually very simple. Follow these steps and you will soon know the correlation of the currencies that catch your eye:

1. Download historical price data of the currencies you are interested in;
2. Import them into an Excel spreadsheet;
3. Use the correlation function =COEF.DE.CORREL(matrix1;matrix2).

With this method you can select the time range you want and analyse the correlation of currencies. The correlation changes over time, although it should be noted that you don't have to repeat this calculation every day. You can recalculate the correlation every week or at least once a month.

Correlation for Forex

The correlation of currency pairs is a crucial element that all investors should be aware of. This factor is vital to protect investments from market volatility, as positively correlated currencies can be affected by the same factors. To understand currency correlation in Forex, it is important to remember that all currency pair trading actually involves derivatives of the US dollar. While the logic behind this phenomenon may seem simple, it is actually much more complicated than that.

One of the most important elements in this regard is the currency correlation chart, which illustrates the relationship between different currencies over a period of time. With the help of this tool, it is possible to predict the direction of price movements in Forex. Example: if the Yen and the EU dollars have a positive correlation, it means that when one of them rises in price, the other will also rise in price according to the value of its correlation coefficient.

How to trade currency correlations?

Building on this concept, you can develop a currency correlations strategy to create contingencies in your investment portfolio. However, remember that correlations are not fixed and will change in the future. To develop such a strategy, you should consider the following steps:

• Do not trade negatively correlated pairs: Two negatively correlated pairs will move in opposite directions. This means that profits made on one pair will be reduced by losses on the other pair;
• Diversify your risks: Trade currency pairs with positive correlation. This way you can reduce your risks in the long run, while your positions will continue to be profitable;
• Hedge your risks: Negative correlations are not always problematic as they can be used for hedging. Imagine you have opened positions in two currency pairs with near perfect negative correlation. In case one of the pairs shows a loss, the other will show a profit. It is worth noting that you will not make a profit with this method, but you will be able to significantly reduce your losses.

Forex currency correlation strategy

Frankly speaking, there is no specific strategy that actively applies currency correlations. Likewise, there is no financial instrument suitable for implementing such a strategy. However, some traders use a method of investing that involves currency correlations. This strategy consists of managing a large number of currency pairs (usually 20 or more) with correlations ranging from -0.2 to +0.8. The goal of this method is to trade all of these pairs and offset losses on one instrument with gains on another. For example, if a trader has losses on EUR/USD, he can cover them with profits on a negatively correlated pair such as EUR/GBP. With this method, it is possible to make small amounts of money in a short period of time.

Before investing real money in this strategy, it is recommended to use a demo account to learn the advantages and disadvantages. It is also a good idea to divide your portfolio into different categories, such as "negative correlation group", "positive correlation group", etc. The concept behind this strategy is to open positions in multiple pairs at the same time. For example, you can try opening 10 positions on different pairs while trying to hedge your losses using correlations.

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Factors when calculating the strategy

To successfully use our strategy, we need to take into account several important factors and one of them is seasonality. The correlation of currency pairs can vary significantly depending on the time frame. For example, when analysed on a 1-hour chart EUR/USD and EUR/GBP show a strong negative correlation, but on a 1-year time frame the picture is reversed. Therefore, seasonality plays an important role in the strategy and should be constantly taken into account.

It is also important to know your instruments well. You must understand which currency pairs you are going to work with, otherwise it will be difficult to predict their future prices. It can be difficult to create a portfolio of 20 or more pairs at once, but gaining experience will allow you to make more balanced investments. Don't forget to analyse correlations, there are many methods to do this: using formulas in Excel, correlation tables available from various sources, or special indicators on trading platforms. Once you have done all these steps, you will be aware of the possible correlations between the selected currency pairs and you will be able to trade based on this theory. Keep in mind that the transaction costs of using this strategy can be very high in highly seasonal environments due to swaps.

It's worth noting that you don't necessarily need to trade in the long term, although you can use correlations on higher time frames to validate your short-term positions. Before investing real money in this strategy, it is recommended that you use a demo account to learn the advantages and disadvantages. It is also a good idea to divide your portfolio into different categories, such as "negative correlation group", "positive correlation group", etc. The concept behind this strategy is to open positions in multiple pairs at the same time. For example, you can try opening 10 positions on different pairs while trying to hedge your losses using correlations.

Conclusion

Using currency correlations in the Forex market can be a powerful tool in a trader's arsenal. Correlations can change over time and under the influence of various factors, so regular analysis and adjustment of strategies are important aspects of successful trading. Before using a currency correlation strategy on a live account, it is recommended to test it on a demo account to better understand its advantages and disadvantages. Remember that successful trading requires not only knowledge and skills, but also constant analysis and adaptation of strategies. By following these principles, you will be able to effectively use currency correlation to achieve stable profits in the Forex market.

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