Currency Pair Correlations: Understanding and Utilising in Forex Trading

In the world of forex trading, understanding the correlations between currency pairs is crucial for effective trading. Currency pair correlations refer to the statistical measure of the relationship between two FX pairs and how they move in relation to each other. By analysing these correlations, traders can predict which currency pair rates are likely to move in tandem. In this article, we will delve into the concept of currency pair correlations, explore their significance in forex trading, and discuss strategies for utilising them to optimise trading outcomes.

Defining Currency Pair Correlations

Correlations between currency pairs emerge from the mutual dependence of currencies, which are quoted in pairs. For example, when the GBP/JPY pair is traded, it’s essentially a derivative of the GBP/USD and USD/JPY pairs, leading to a certain degree of correlation with one or both of these pairs. However, it’s crucial to note that this kind of triangulation only happens with FX crosses, i.e., pairs that do not involve the USD. Beyond this, the correlation between currency pairs is more complex. Some pairs move in the same direction, while others move in opposite directions, under the influence of intricate forces.

Correlation coefficients measure the degree of correlation between two currency pairs and range from -1.0 to +1.0. A correlation of +1 implies that the two currency pairs move in the same direction 100% of the time, while a correlation of -1 implies that they move in opposite directions 100% of the time. A correlation of zero indicates a completely random relationship between the currency pairs. However, it’s important to note that in real-world markets, achieving a perfect +1 or -1 correlation is nearly impossible.

Reading the Correlation Table

With this knowledge of correlations in mind, let's look at the following table showing correlations between the major currency pairs (based on actual trading in the forex markets recently).

EUR/USD Correlation Table

The upper table above shows that over one month the EUR/USD and GBP/USD had a very strong positive correlation of 0.95. This implies that when the EUR/USD rallies, the GBP/USD has also rallied 95% of the time.

Source: Investopedia

The Importance of Monitoring Correlations

Currency pair correlations, which are not static and can fluctuate over time, refer to the statistical relationships between two currency pairs. Regular monitoring and tracking of these shifts in correlations is essential for informed trading decisions.

Retail traders can use platforms like TradingView where they can observe currency correlations by identifying which currency pairs have a positive or negative correlation to each other.

Sentiment and global economic factors are dynamic and can change on a daily basis, impacting currency pair correlations. Strong correlations observed today may not align with longer-term correlations. Thus, it is essential to consider the six-month trailing correlation, which provides a more accurate perspective on the average relationship between two currency pairs.

Correlations change for various reasons, including diverging monetary policies, currency pair sensitivity to commodity prices, and unique economic and political factors. For instance, changes in oil prices can have a significant impact on the Canadian and U.S. economies, leading to a sharp reaction in the USD/CAD currency pair.

Here’s an example how:

Impact on the Canadian Economy: When oil prices are high, Canada earns more U.S. dollars for each barrel of oil it exports. This increases the supply of U.S. dollars flowing into Canada relative to the supply of Canadian dollars, resulting in an increase in the value of the Canadian dollar. Conversely, when oil prices are low, the supply of U.S. dollars flowing into Canada decreases, leading to a decrease in the value of the Canadian dollar.

Impact on the U.S. Economy: Lower oil prices can benefit most consumers with cheaper gasoline and travel, as well as lower prices of many manufactured goods. However, now that the U.S. has increased its oil production, low oil prices can hurt U.S. oil companies and affect domestic oil industry workers.

Impact on USD/CAD Currency Pair: The USD/CAD currency pair is directly affected by these economic impacts. The Canadian dollar (CAD), often correlated with oil prices, tends to rise in value relative to the U.S. dollar (USD) when oil prices increase, and vice versa. Therefore, higher oil prices lead to a decrease in the USD/CAD value (strengthening CAD), while lower oil prices lead to an increase in the USD/CAD value (weakening CAD).

It’s important to note that these are general trends and actual market movements can be influenced by a variety of factors.

Calculating Currency Pair Correlations

To stay updated on the direction and strength of currency pair correlations, it is advisable to calculate them independently. Although this may sound daunting, it is relatively simple with the help of software or spreadsheet programs like Microsoft Excel.

Here is a step-by-step process for calculating currency pair correlations:

1. Obtain pricing data for the two currency pairs you want to analyse (e.g., GBP/USD and USD/JPY).
2. Create two columns labelled with the respective currency pairs and fill them with the past daily prices for each pair over the desired time period.
3. In an empty slot at the bottom of one of the columns, type in the correlation formula: =CORREL(.
4. Highlight all the data in one of the pricing columns to get a range of cells in the formula box.
5. Type a comma to denote a new cell.
6. Repeat steps 3-5 for the other currency pair.
7. Close the formula so that it looks like =CORREL(A1:A50, B1:B50).
8. The resulting number represents the correlation between the two currency pairs.

While correlations change over time, it is not necessary to update the calculations daily. Updating them once every few weeks or at least once a month is generally sufficient to stay informed about the shifting trends in currency pair correlations.

Utilising Currency Pair Correlations in Forex Trading

Having a deep understanding of currency pair correlations allows traders to optimise their trading strategies. Here are two ways to utilise currency pair correlations in forex trading:

Identifying Hedging Opportunities

Currency pair correlations can be utilised for hedging purposes. When two currency pairs exhibit a negative correlation, traders can take advantage of this by hedging their positions. For example, if a trader holds a long position on EUR/USD and a short position on USD/CHF, they can offset potential losses in the EUR/USD position with profits from the USD/CHF position. This hedging strategy helps mitigate risk and protect against adverse market movements.

Leveraging Pip or Point Values

Traders can leverage the different pip or point values of currency pairs to their advantage. For example, let's consider the EUR/USD and USD/CHF, which exhibit a near-perfect negative correlation. While their movements are inversely related, the value of a pip move in the EUR/USD is $10 for a lot of 100,000 units, whereas the value of a pip move in USD/CHF is $9.24 for the same number of units.

By carefully managing their positions and leveraging currency pair correlations, traders can optimise their risk-reward ratios and potentially enhance their overall trading performance.

Conclusion

Monitoring correlations regularly helps traders stay updated on shifting trends and adjust their strategies accordingly. Whether for hedging purposes or leveraging pip values, currency pair correlations provide valuable insights.