Whether you’re trading a single currency pair or the whole lot, you have to know how different forex pairs move in tandem with each other. Since no financial instrument or currency pair can exist in a vacuum, monitoring and analyzing them to determine their relationship is detrimental to any trader. In the terms of trading, correlation is the statistical measure of how two assets relate to one another.
Once you have worked it out, you could use the information to either increase your profits or hedge against your trading position. However, if the market moves against your position then you could end up losing more too. We’ll get into more of that later, but before let’s discuss currency correlation in depth.
Currency correlation indicates the relationship between two separate currency pairs, whether they move in the same, different, or random direction in the market. A positive correlation means that the two currency pairs move nearly identical in the same direction. While a negative correlation signifies that the two currency pairs move in the opposite directions.
The correlation coefficient in forex trading measures the strength of correlation between two currency pairs. They are expressed in values ranging from +1 to -1, where +1 implies perfect positive correlation and -1 implies perfect negative correlation. And if the correlation coefficient is zero then there is absolutely no relation between the two currency pairs. How strong or weak the relationship between two currency pairs depends on factors such as time of the day, trading volume, etc.
The currencies with strong economic ties are usually highly correlated. For example, the correlation between EUR/USD and GBP/USD is quite high because of their geographical proximity and strong economical relationship.
So how could you advantage of all this information while trading? Well, if we know that two currency pairs have a positive correlation then you could open two of the same trading positions and benefit from them both. And if the price goes down, then you end up suffering loss from both positions. And where there is a negative correlation, two opposing trading positions would be more suited. Traders usually take up positions on correlated currency pairs to diversify their positions while investing in the same market direction. It can be also used as a hedging strategy by buying two currency pairs with negative correlation and thus offset the risk.
Correlation isn’t limited to just currency pairs. More or less every asset in the financial market share peculiar relationships with one another. All you need to do is observe and decipher how this could help you with your trading.
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