By Igor Titara for Forex Article Contest
Given the volatility of the day, different currency pairs can have a positive or negative correlation. In financial markets, correlation is a measure of variation between two financial instruments. When two currency pairs move in the same direction, we have a correlation of +1 or almost 100 %. When two currency pairs move in the opposite directions, we have a low correlation of almost -1 or -100 %. Hardly, you’ll find a perfect correlation rate, + / – 1.
See a correlation table to look how random the currencies can be.
For example, if AUDUSD and NZDUSD have a correlation of +0.95, it means that the two currency pairs will move 95% of the time at the same direction.
A practical example is the correlation between EURNZD and NZDUSD.
Example, the NZDUSD is rallying during the day, so the EURNZD will depreciate the same day because the two currency pairs have a negative correlation.
In this graph, EURNZD has a bearish outlook.
In this graph, NZDUSD has a bullish outlook.
Notice that the EURNZD has an opposite movement. Fortunately, the degree of correlation varies everyday with economic news and their volatility. Political uncertainties and decisions on interest rates, for example, can greatly influence the movement of a financial instrument. If the trader decides to apply two different orders with different correlation, there is a probability of better diversification of investment with better profits.
Buying 100,000 units of EUR/USD, taking $10 per pip, and selling 100,000 of USD/CHF, taking $9.1 per pip, the investor will achieve a profit of $19.1 and will diversify the portfolio.
However, if you buy 100,000 units of EUR/USD profiting $10 per pip and sell 100,000 units of USD/JPY with $ -9.2 of loss, your investment will have $0.80 profit…
EUR/JPY has great positive correlation with USD/JPY
USD/CHF has excellent correlation with USD/JPY
GBP/USD has a strong correlation with EUR/JPY
Japanese currency pairs generally move in the same direction. Of course, every country does different actions about their policy about currency fluctuation or inflation. Such changes will move faster one currency against the other. If you see a Stoch or CCI extremely overvalued on the EUR/JPY, you can also notice pairs like USD/JPY overvalued.
A bearish candle may indicate impairment in Japanese pairs. Therefore, you can buy USD/JPY and EUR/JPY at the same time. Or sell USD/JPY and buy USD/JPY if the correlation of pairs is changed within a day due to high volatility.
Utilizing correlation’s degree can be useful for determining a hedging strategy. For example: If the EUR/USD has a negative correlation against the EUR/JPY, so it is preferable to sell EUR/USD and buy EUR/JPY with some profit target. Or when buying and selling EUR/USD, you can overcome the negative equity longing EUR/JPY if and only if Japanese pairs have negative correlation with EUR/USD.
Summing up, correlation indicates what kind of currencies is more interesting to trade. If major currencies show positive correlation, so there is no reason thinking about short instruments.
Before entering a trade, look a correlation of 80% up to 90% between currencies, thus you will see what direction to choose.
The article is written by Igor Titara and is participating in the Forex Article Contest. Good luck!