In order to get a better idea about what does the currency correlation mean and the mechanics of this subject, let us take a look at this correlation table:
The correlation is measured by a coefficient, which can range from -1 to +1. For example, 1.00 means that two currency pairs move exactly the same way. The opposite is true for -1.00.
The basic explanation is that:
- Coefficients range from -1 to +1
- +1 or 1.00 means that currencies are identical in a way how they move
- -1 or -1.00 means that currencies move completely the opposite way
The table itself shows the correlation coefficient, using hourly movements for the last 300 trading hours. Simply taking and analyzing data for only one day can be misleading, since some particular events might disrupt the market. However, using such a larger sample could be much more useful.
Nowadays traders do not have to necessarily know how to calculate currency correlation. Many trading platforms and Forex news websites provide this type of information. For example, this table was constructed, using the numbers from the Forex correlation calculator at investing.com.
So what is the meaning of currency correlation data? How can we interpret this?
As we can see here, for example, the coefficient for EUR/USD and GBP/USD is 0.94. This suggests that those two pairs very often move in tandem. In fact, they are not very far from almost a perfect correlation.
On the other hand, the coefficient for USD/CAD and Gold is -0.67. In this case, those two securities often move in opposite directions.
Not all of the securities are closely connected to each other. For example, on the table, the combination USD/JPY and Gold shows -0.45. This does suggest that there is some negative correlation, but it is relatively weak, so it might not be advisable to make trading decisions, based on their relationship. Many traders are looking for pairs with a minimum of 0.6/-0.6 coefficient in their analysis.
How some traders magnify their risk exposure without knowing it
We know that most of the experts and experienced traders advise us not to risk more than 5% of trading capital on a single trade. This makes sense, however considering the things we discussed above, it seems traders might take on more risk than they realize.
In order to get a better understanding of the currency correlation meaning, it can be helpful to turn to some practical examples.
Let us suppose that the trader has $10,000 on a trading account. He or she takes the advice of professionals in the field and only risks $500 (5% of the Funds) in every single trade. So the trader has opened long EUR/USD, GBP/USD, and short USD/JPY positions.
If one has no idea what a currency correlation is, then at first glance, this might seem like a well-diversified trading portfolio, with reasonable risk management. However, this line of reasoning ignores the dynamics of currency correlation. As mentioned before the coefficient for EUR/USD and GBP/USD is 0.94, at the same time both of those pairs USD/JPY have a very strong negative correlation between -0.87 and -0.92.
Essentially those three positions very often move towards the same direction. So instead of only risking 5% of the funds, in real terms, the trader risks 15% of the account and if things go wrong, the losses can be considerable. This is something to keep in mind, before opening several positions.
Positively correlated pairs can also be utilized in a different way. For example, a day trader might be looking for an opportunity to open a position with the AUD/USD pair. However, the economic data might be contradictory and there are no clear technical indicators. So it is very uncertain in which direction the market will go.
In this case, he or she can take a look at the latest correlation data and take a look at those currency pairs and commodities, which have a high coefficient with AUD/USD. Therefore, looking at GBP/USD or Gold price might be more informative during this process of decision making.
How can negatively correlated pairs be used for trading?
The currency pairs with negative correlation can be just as useful as the examples mentioned above. In fact, sometimes they can be utilized as some sort of insurance policy against the potential losses.
How is this possible? Well, let us return to our previous example. Suppose, that because of the rising Gold price, the trader decides to open a long AUD/USD. In order to hedge against the risk, it is possible to open a long position with the pair with a very strong negative correlation, for example, USD/JPY. Since those two pairs mostly move in opposite directions, then the loss in one case can be compensated by profits from the second trade.
Now there is an obvious question: what sense does this make? Those two positions will cancel each other out and the trader will end up with zero profit. Is this not the most likely outcome?
Well, not necessarily, the trader is not obligated to close those two trades at the same time. Let us say that after placing those trades, AUD/USD fell by 0.5% and USD/JPY has risen by the same percentage. If the direction of the market is clear, the trader can close losing the AUD/USD position, while keeping USD/JPY open.
In the worst-case scenario, if suddenly the market changes direction, the long USD/JPY position can be liquidated to offset some of the earlier losses. On the other hand, if the pair keeps rising and ends up appreciating, say by 0.7% or even 1%, then the trader can close this position and make a nice profit.
Obviously, none of those strategies can have a 100% success rate, but this can work in many cases.
Exceptions to the rule
As we can see in most cases the correlation coefficient measure of different currencies can be very helpful in identifying potential trends. However, just like with every other rule, here also are some exceptions.
Australia is a major producer of Gold, therefore it is not surprising that AUD/USD and XAU/USD have a notable connection. In fact, in the table above the Forex currency correlation indicator shows 0.76, which is significant.
So how can the Australian dollar fall, even in times of rising Gold prices? Or how does the AUD appreciate during a time when precious metals are becoming cheaper?
Actually, there can be several scenarios of that nature. For example, because of fears of recession, the demand for Gold might increase and push the price higher. While in the meantime, because of the same concerns the Reserve Bank of Australia, might decide to cut the cash rate to stimulate the economy. As a result, the investors and traders might be less attracted to the lower-yielding Australian dollar and AUD/USD might fall significantly.
It does not even have to do with the Reserve Bank of Australia. All currency pairs have two parts of the equation. It might happen, for example, that the Gold price starts to fall and at the same time the 10 year US treasury yields decline significantly In this scenario USD might lose the traction and AUD/USD could rise, despite the precious metals losing ground.
Therefore the currency correlation observations must be combined with the fundamental analysis since such factors as monetary policy decisions, geopolitical events, and even regular economic data releases can easily disrupt the normal behavior of currency pairs.
One example of this might be the performance of the British Pound during and after the 2016 EU referendum. We have already discussed that EUR/USD and GBP/USD have a very high correlation coefficient. As a result, those two European currencies do not move much against each other and EUR/GBP is much less volatile than most of the other pairs. So in this case, a 1% change in a day can be noticeable.
As the referendum results started coming in and after some hours it became apparent that the ‘remain’ side lost the campaign, the pound started free falling. The British currency lost 10% against USD and even traditionally less volatile EUR/GBP has risen by more than 7% in a single day.
This is just another example, confirming the savvy trader should not always trust the past market patterns during the decision making.