What is Currency Correlation? And How to Use It in Forex Trading
Reading time: 15 minutes
Trading Forex requires great knowledge of technical indicators and fundamental events. Although most traders tend to focus on one of the aforementioned approaches, today, more and more attention is being paid to proper trading psychology and risk management. This is where currency correlation comes into play.
Currency correlation is strongly connected with risk management, and can help you to better understand the market when trading. Understanding of the correlation between currency pairs helps you avoid overtrading, and to use your margin to hold less desired assets. This article will explain what currency correlation is, how to understand it, and, ultimately, how to improve your trading strategy by adding currency correlation knowledge to it.
What is Currency Correlation?
Source: MetaTrader 4 - Correlation Matrix - Currency Pairs
It's easy to see why currencies are interdependent. If you are trading the British pound against the Japanese yen (GBP/JPY), you are actually trading an offshoot of the GBP/USD and USD/JPY pairs; both currencies – GBP/JPY – share a relationship with the US dollar and as such, a correlation to each other. While some currency pairs will move in the same direction, others may follow the opposite direction. This is the result of more compound forces.
In financial terms, correlation is the numerical measure of the relationship between two variables. The range of the correlation coefficient is between -1 and +1. A correlation of +1 denotes that two currency pairs will flow in the same direction. A correlation of -1 indicates that two currency pairs will move in the contradictory direction 100% of the time, whereas the correlation of zero denotes that the relationship between the currency pair is completely arbitrary.
If you would like to find out what are the best currency pairs (according to professional traders), why not check out the article below, and see which ones are best for you?
The Difference Between the Currency Strength Meter and the Correlation Matrix
There are quite a few issues with poorly coded currency strength meters. If a currency strength meter doesn't provide accurate currency strength indicator values, it's of little use, regardless of its other features. With an outdated currency strength meter, traders might, but not necessarily, experience:
- MT4 freezes
- PC freezes
- Whipsaw signals
- Memory leakage
- CPU working constantly at 100%.
Some products might even produce data that's moved away from the original concept of what currency strength actually is. Some apply smoothing filters, like moving averages. Others apply other filters (e.g. RSI and MACD). This is just a complex algorithm of indicators that might make you enter false trades and losing streaks. The real strength of currency trading comes from correlation. The Correlation Matrix has been coded properly, using the latest technologies, and is unlikely to cause any of the aforementioned issues.
Forex Correlation Matrix
Over the years, the Forex strength meter has naturally evolved into a correlation matrix that could also be more complex and accurate. Forex Correlation, like other types of correlations, is a term designated to signal correlation between two of the pairs. When two sets of data are strongly linked together, we say that they have a high correlation.
When pairs move in the same direction, they have a positive correlation. If they move in the opposite direction, we observe a negative correlation between them. A perfect correlation occurs when pairs move in the same direction, which is extremely rare. Additionally, we say that correlation is high when pairs move in almost the same direction.
Change in Correlation
It's obvious that changes in correlation do exist, which makes calculating correlation very important. Global economic factors are dynamic – they can and do change on a daily basis. Correlations between two currency pairs may vary over time, and as a result, a short-term correlation might contradict the projected long-term correlation.
Looking at correlations over the long term provides a clearer picture about the relationship between two currency pairs – this tends to be a more precise and definitive data point. There are many reasons for a change in correlation. The most common are deviating monetary policies, the sensitivity of certain currency pairs to commodity prices, and political and economic factors.
Calculation of Correlation
The ideal way to strengthen your position is to calculate your correlation pairing yourself. It sounds complex, but actually is quite simple. Just download the award winning MetaTrader Supreme Edition plugin (MTSE) for MetaTrader 4 and MetaTrader 5, and start using it. The program will automatically perform the calculation for you on different timeframes.
Although correlation ratios change, it's not compulsory to update your numbers every day. It is however, a good idea to update them when you change trading time frames. Each country has a different monetary policy in a different cycle, so changes to these will affect some currencies more than others.
The Advantages of Using the Correlation Matrix
Elimination of double exposure: Opening multiple positions with pairs that are highly correlated is not advisable, as it gives rise to more exposure. Moreover, having higher exposure to a particular currency can be harmful should the analysis go wrong. For example, by going long on AUD/CHF, AUD/JPY, and EUR/JPY, a trader gives rise to double exposure if they are highly correlated.
Digging deeper, the aforementioned positions bring double exposure to AUD and JPY, which can be harmful for trade, should the movement go in the opposite direction from the trader's expectations. Knowing the correlation levels between different currency pairs, a trader can gain an idea of how they are connected to each other, and avoid double exposure to a weak currency.
Elimination of unnecessary hedging: If the correlation strength between different pairs is known in advance, a trader can avoid unnecessary hedging. For example, there is a negative correlation between EUR/USD and USD/CHF that restricts taking positions in the same direction. The reason is that when you win on one trade, you are more likely to lose on another trade, whereas volatility makes it uncertain as to whether the gains will surpass losses or not.
Signals high risk trades: Correlation between different currency pairs can also signal the amount of trade strategy risk. For example, if we are going long on EUR/USD and GBP/USD, and both are positively correlated pairs, it signals a possible double risk from the same position, if one of the currencies is strong.
It might also happen that one of the pairs is indicating a strong movement, while the other is just ranging, which signals to avoid entering trades with correlated pairs in the opposite direction. For example, if the EUR/USD is witnessing a downtrend, and the GBP/USD is ranging, a trader should avoid going long on GBP/USD, which carries a higher downside risk due to possible USD strength.
How to Use Currency Correlation in Forex Trading
Understanding correlated currency pairs is vital in determining your portfolio's exposure to market volatility. Since currency trades in these pairs and no pair trades in a vacuum, it's critical to risk the mitigation that you learn about these correlations and how they change.
Source: MetaTrader 4 Supreme Edition - Correlation Matrix
In the Correlation Matrix featured above, positively correlated pairs have shown positive correlation, moving in a similar direction. Negatively/inversely correlated pairs tend to trade in the opposite direction from each other. Correlations are also divided into four groups in accordance with their strength. For easy viewing, all correlations in the following table are coloured to show their strength, as is noted below:
- Green: Little or no correlation
- Blue: Weak correlation
- Orange: Medium correlation
- Red: Strong correlation
Put simply, it matters whether the correlation is positive and/or negative. In the Forex market, currency units are quoted as currency pairs. The base currency – also known as the transaction currency – is the first currency appearing in a pair quotation, followed by the second part of the quotation (known as the quote currency or the counter currency).
The example above shows that CAD is the strongest, as it shows a +91 correlation between USD/CAD and EUR/CAD (CAD is the quote currency). The weakest correlation is between EUR/GBP (GBP is the quote currency) and GBP/CHF (GBP is the base currency) – 96 – which means that the simultaneous positions in this pair within the same direction are very likely to cancel each other out, indicating GBP strength.
Downloading a Currency Strength Meter
MetaTrader 4 is an extremely widespread FX trading platform. One of its advantages is the ability to download and use custom indicators and Expert Advisors (EAs). The MetaTrader 4 platform comes with a useful selection of popular indicators built into the client terminal. You can also download independently written custom indicators.
As MetaTrader 4 is an open platform and has such a wide community of users, indicator innovations move fast. There are thousands of custom indicators available for analysing the Forex market, using different algorithms. You can search for custom indicators from within the chosen platform. Some charge money for the full version, but some are entirely free to download, such as MTSE.
Whenever you consider paying for a trading aid, remember that any reputable provider will offer a free trial version, and you can even program an algorithm yourself. It is highly recommended for professional traders to download MetaTrader 4 Supreme Edition – because it is an extended version of the client terminal. It includes many features, and not just the currency strength meter, but it also includes features such as the live trading simulator for backtesting strategies.
It also enables you to add different custom indicators and EAs that you might benefit from. Once you've downloaded the MetaTrader 4 Supreme Edition plugin (which includes the currency strength meter), you are ready to go!
Correlation Trading Tips
Bear in mind that correlations do change, and past performance is not always a guaranteed indicator of future correlations. However, this information can be used to develop your own currency correlation strategy, to minimise your portfolio's exposure. Here are some tips to consider:
- Avoid positions that cancel each other out: If you see two currency pairs that move in opposite directions nearly all of the time, you should realise that holding long positions in both of those currencies mitigates any potential gain that could be had.
- Diversify with minimal risk: By investing in two currency pairs that are almost always positively correlated, one can mitigate risks over time, while maintaining a positive directional view.
- Hedge exposure: Losses can be minimised by hedging two currency pairs that hold a near-perfect negative correlation. The reasoning here is simple. If you hold a position with a currency pair that loses value, the opposing currency (which has a negative correlation to that pair) will likely gain, albeit with a lower final value. While such a strategy won't completely mitigate losses, those losses will very likely be reduced.
Forex Currency Correlation Strategy
In the last few years, it has become quite common to trade currency correlations in regards to extending your portfolio of trading assets to 20 or more currency pairs with strong correlation. Here are different examples of correlations:
- Positive Green: Little or no correlation. Positions on these symbols will tend to move independently and have profitability, which are not related to each other.
- Negative Green: Little or no correlation. Positions on these symbols will tend to move independently and have profitability, which are not related to each other.
- Positive Blue (up to +30): Weak correlation. Positions on these symbols will tend to move independently and have profitability, which are not related to each other.
- Positive Blue (up to +49): There may be similarity between positions on these symbols. Positions in the same direction may have similar profit. Positions in the opposite direction may offset each other.
- Negative Blue (up to -30): Weak correlation. Positions on these symbols will tend to move independently and have profitability, which are not related to each other.
- Negative Blue (up to -49): There may be similarity between positions on these symbols. Positions in the same direction may offset each other. Positions in the opposite direction may have similar profit.
- Positive Orange (up to +75): Medium positive correlation. Positions in the same direction on these symbols will tend to have similar profit. Positions in the opposite direction will tend to cancel each other out.
- Negative Orange: (up to -75): Medium negative correlation. Positions in the same direction on these symbols will tend to cancel each other out. Positions in the opposite direction will tend to have similar profit.
- Positive Red: (up to +100): Strong positive correlation. Positions in the same direction on these symbols are very likely to have similar profit. Positions in the opposite direction will cancel each other out.
- Negative Red: (up to -100): Strong negative correlation. Positions in the same direction on these symbols are very likely to cancel each other out. Positions in the opposite direction will have similar profit.
It's a relatively simple concept that allows you to judge the raw strength of a currency in isolation, as opposed to seeing what it is doing against another currency. The calculation method may vary according to which Forex meter you use. One of the best known measures of a currency in isolation is the aforementioned base vs quote currency concept. This gauge calculates the value of all available currencies relative to each other.
These currencies are:
- The Euro (EUR)
- The Japanese Yen (JPY)
- The British Pound (GBP)
- The Australian Dollar (AUD)
- The Canadian Dollar (CAD)
- The Swedish Krona (SEK)
- The Swiss Franc (CHF)
- The Hungarian Forint (HUF)
- The Polish Zloty (PLN)
- The Norwegian Krone (NOK)
- The Singapore Dollar (SGD)
- The Mexican Peso (MXN)
- The Russian Rouble (RUB)
A less-known, but a more comprehensive measure is the broad USD index, which uses a wider selection of currencies. Both work in a similar way. They calculate the strength of the Dollar by aggregating bilateral exchange rates into a single number, and then applying a weighting for the currencies included.
The weighting applied for the broad index is a trade weighting, derived from trade data. Specifically, this is the share of merchandise imports in annual bilateral trade within the U.S. The Correlation Matrix uses complex algorithms, but is very easy to use. It even allows you to choose a strength for a certain period of time. For intraday trading, it is recommended to use up to 200 bars, while for scalping, up to 50 bars should be enough.
Source: MetaTrader 4 - Selecting bars and time frames within the Correlation Matrix
- Scalping: M5, 50 bars
- Intraday trading: H1, 200 bars
- Intra week swing trading: H1, 500 bars or H4, 200 bars
Once you have a better overview of the correlations, and their possible impact on the price, you can start trading correlation for the pairs of your choice. It is always recommended to to start with demo account trading first. The main idea would be to open around 10 positions at once. Try to first split your portfolio into premier categories – e.g. pairs that have negative correlation. After that, try to make sure that these pairs do not correlate with each other to a larger degree.
When you see price movements, identify the direction of the trade, and remove the losing positions from your portfolio. You might also want to attempt to trade strongly correlated pairs, but keep in mind that you will probably be double-exposed to a currency. Sometimes, it might actually be a good way to trade, especially if the strength of a currency is supported by an economic fundamentals or important news events.
A good tip to give here is to consider setting your stop-loss on the winning trade, so they are at least equal to the loss that resulted from the closure of the losing trade, plus the cost of the spread and the cost of commission (if any) plus one pip on top of that. This way you could secure a small gain on your profitable trade.
This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.