Using Correlation in Currency Trading

When you first start in currency trading, you may be unaware that some currency pairs seem to move in opposite directions. Understanding and using the relationship of pairs to one another is crucial to your long term success in the market. Many traders are simply unaware of these relationships, and wonder why their trading positions remain static or hugely negative when they have several open positions. The reason is simple – it is called correlation.

Correlation has two aspects as data pairs can either correlated inversely or directly. If two data sets are perfectly correlated in an inverse relationship, then the correlation factor is -1. In other words for a unit of movement up by one data set, then the other data set will move down by one. The closer data sets are to the factor being one ( or minus one) then the closer they are correlated. If two data sets are directly correlated, then as one data set moves by one unit, then the other will move in the same direction by the same amount.

I do not propose to explain the maths of calculating the values, but it is important when trading, to understand these relationships between currencies. I is also important to appreciate that whilst two pairs may relate to one another over a period of a few hours or days, this does not necessarily mean that this will continue for weeks or months. Various factors may affect this relationship where the correlation value falls or becomes meaningless. As a rule of thumb, if this is below 0.85, then the relationship has less meaning.

So how do I use this information in my trading? In currency trading these relationships are important for two reasons. Firstly it allows you to identify pairs which can be used to hedge a trading position, and secondly (which is the converse of this I suppose), you do not want to open directional trades and suddenly find that you have two trades which are hedging one another and therefore not going in any direction at all!! Those currencies which tend to correlate quite well are GBP/USD and EUR/USD which correlate positively, and the USD/CHF which correlates negatively, particularly with the EUR/USD.

If a pair correlates perfectly and is a direct relationship then buying one and selling the other will work as a hedge ( in the same quantities ) For example, suppose we think the EUR/USD is going up, this implies that the USD/CHF is going down. If we bought 5 contracts of the first pair and sold 5 contracts of the second, if they were in perfect inverse correlation, our balance would stay much the same. In order to make money, we could therefore decide to weight our decision, but still use a hedge. By buying 5 contracts of the first pair as before, but only selling 3 of the second, we still have a hedge if it all goes wrong, but we have weighted our decision by 2 contracts on the EUR/USD going up.

Using hedging and correlation is a powerful way to spread and manage the risk in your currency trading.