Advanced risk management
Currency correlation in forex trading
Financial markets rarely move in isolation. A trend in one asset will often ripple around several others, meaning some prices rise as others fall.
This effect is called market correlation. While it can be useful for spotting opportunities, it can also increase your risk if you aren’t careful. But by understanding how correlation works in forex trading, you can take a significant step towards lowering your overall risk.
- What is market correlation?
- Types of correlations
- Example of currency correlation
- Which currency pairs are correlated?
- Why correlations are important
- Commodity correlations
- Correlation between currencies and stocks
- Currency correlation: Trading tips
What is market correlation?
Market correlation is a measure of how much assets move in line with each other. You can measure the correlation of specific markets, industries or entire asset classes. That being said, it should also be noted that there is no guarantee that the two will be or likely to be correlated in the future.
Correlation is usually measured as a percentage. If two markets are 100% correlated, then their movements will always be the same. When one rises, so will the other. This is called a perfect correlation.
A 50% correlation, meanwhile, means that the two markets generally move in the same direction but may not always follow each other in lockstep.
Types of correlations
There are three types of correlation:
- Positive correlation describes markets that mimic each other's movements
- Negative correlation describes markets with inverse movements
- No correlation describes markets with no relation whatsoever
|-60 to -100% Strongly negatively correlated||-20 to -60% Slightly negatively correlated||-20-20% Essentially uncorrelated||20-60% Slightly correlated||60%-100% Strongly correlated|
Example of currency correlation
To illustrate, here is a correlation coefficient table for EUR/USD, showing how this major pair relates to three other major currency pairs over various time periods. Notice how GBP/USD shows a positive correlation, but the currencies generally recognized as “risk off” (the Swiss Franc and the Japanese Yen) in this example show a negative one.
EUR/USD correlation with other pairs
Data accrued from June 4, 2020 to June 3, 2021. Source: Yahoo Finance
Which currency pairs are correlated?
The key currency pairs that are correlated in the strongest way include pairs such as EUR/USD and GBP/USD, as can be seen above. They often move together due to the economic relationships between the areas they represent.
In this case, GBP and EUR have close ties based on the Eurozone and the UK sharing geographical proximity, as well as backup reserve currency status. Also, the fact that both these pairs share the USD as a counter currency means that any change in the dollar is reflected in both currency pairs simultaneously. See below how the price lines tend to move in similar ways with one another.
Other pairs that tend to show a strong correlation are EUR/USD and AUD/USD, and EUR/USD and NZD/USD.
Why correlations are important
Correlations can have a significant impact on your overall risk level and your bottom line, mainly because they act against diversification, and can mean that one market moving against you impacts your entire portfolio.
For example, if you have open short positions on two markets with a 75% positive correlation, then it is probable that a bear trend in one will lead to the same move in the other.
In this case, you risk losing the capital allocated to both positions if one moves against you. Therefore, your total risk from the trade could be higher than you originally planned.
If you have multiple correlated positions, your overall risk on a portfolio level could be far higher than you think. So it's always worth researching which markets are related and which can add to your diversification.
Profiting from correlations
You can also use correlations to target profits. One stock trading strategy, for example, involves finding correlated companies and monitoring their price action. If one stock diverges from the rest, you can take a position on its eventual return to the norm. The same can be done in forex trading.
Volatility can have an impact on correlations. In times of high volatility, markets tend to become more correlated, which may increase your overall risk.
Some correlations are only temporary, while others have lasted for years and will likely continue. That being said, it should also be noted that there is no guarantee that the two will be or likely to be correlated in the future. Here are some common examples to be aware of in your trading.
1. USD and gold
Perhaps the best known correlation of all is between the US dollar and gold. Gold is priced in US dollars, so its price is hugely dependent on the strength of the currency. When USD rises, gold’s price will often fall – a strong negative correlation.
2. AUD/USD and copper
Lots of currency pairs are closely correlated to commodities. This usually occurs when an economy is dependent on commodities to grow. Australia, for instance, derives a large portion of its wealth from metals mining. So the price of AUD/USD can move as copper prices move.
3. USD/NOK and Brent crude
USD/NOK, on the other hand, has an inverse correlation with the price of Brent crude. Why? Because Norway is one of the top exporters of Brent, which accounted for some 18% of its GDP in 2018.
Correlation between currencies and stocks
The correlation between currency pairs and the stock market is also a notable phenomenon for those interested in how markets interact, though the relationship can be complex. During risk-on times, traders may go long on certain growth stocks, and temporarily neglect risk-off markets such as gold. But stock market activity can also be influenced by forex considerations, too.
For example, in the UK, a falling pound has often resulted in a rising UK FTSE 100 index, and vice versa, as can be seen in the example below. This is because many companies in the index make a large proportion of their profits in US dollars. When these international transactions are converted back into pounds, they are worth more when sterling is weak.
On the US side, there are varying insights on the impact of the strength of USD on stocks. As the US dollar weakens, the revenues generated by exports are larger when converted back into dollars (the same principle as the example above). Correspondingly, a stronger dollar means US multinationals get less favourable exchange rates when international profits are translated back into USD.
For both USD and GBP, it’s worth remembering that export revenues account for varying proportions of trade from stock to stock. Larger companies naturally do more business outside of the US, meaning a weaker dollar may favour the largest multinationals. Naturally, the flipside is that a weaker dollar means imports are more expensive, so make sure to research company trade patterns for a more tailored feel.
Currency correlation: Trading tips
- Be aware that particular correlations that hold firm ‘on average’ may show periods of weakness. This makes it important to look at both shorter-term and longer-term correlations. A correlation coefficient indicator can be added to a FOREX.com trading chart to help better understand the relationship between markets.
- When placing a trade, consider whether the markets are currently correlated, whether one market leads another, and whether price is diverging. For example, if one market is making lower lows or higher highs and the other is ranging, it may be worth waiting for a period of sustained correlation.
- While trading inversely correlated markets may create scenarios where your trades simply cancel each other out, these trades can also be made for hedging purposes. For example, trading EUR/USD with USD/CHF may not be advisable in the long term, but there may be scenarios where doing so can protect against short-term negative moves.
- Pairs such as AUD/USD are historically positively correlated with gold. With Australia being a major gold producer, the AUD/USD price may vary depending on Australia’s capacity to export the metal. Therefore, any correlation trader should be well informed on fundamental factors impacting gold production schedules and demand patterns.
Test your knowledge
- A Move up
- B Move down
- C It’s impossible to say