Lesson 1: What is Currency Correlation in Forex?

If you've been trading forex and were exposed to different markets, you've probably noticed these forex trends when, 

One currency pair appreciates, another currency pair depreciates 

Or when, 

Two currency pairs thread in the same direction.  

What do you call that trading phenomenon? Are these simply coincidences? No.  

You've just witnessed the currency correlation, or when the two assets move in relation to each other.

Lesson Highlights

• Currency correlation shows the movement relationship of two currency pairs through the correlation coefficient.
• The correlation coefficient is a statistical measurement showing how strong, weak, or irrelevant the relationship between the two currency pairs is.
• Trading the currency correlation is an effective risk management technique as it prevents traders from overexposing their trades to a single and look-a-like risk.

How Currency Trading Works 

When you trade forex, you basically buy and sell a currency pair, hoping to profit from the market volatility. 

But in what direction should you position your trade?  

When is the best time to buy or sell a currency pair? 

Well, you should base it on the market behavior. If the market is expected to appreciate, opening a long position is profitable. If it's to depreciate, you can execute a short position to profit from the market trend. 

Risk of Overexposure 

Overexposing your trades happens when you over-commit and over-invest in a single position or market. If you do this, you invest a big chunk of your capital in a single risk.   

If this happens, a small market swing will wipe out your investment if it goes against your position.   

So, how do you battle this? To avoid this, you should diversify your trade while considering the currency pair correlation.   

Remember, one risk of overexposure is when you target a single market. However, trading on two currency pairs with a positive correlation will yield the same result: overexposure.   

When you trade two positively correlated, it's like you're trading a single market because the market tends to move in the same direction.   

So, it's best to trade two pairs that are negatively correlated. This way, the two pairs move in a different direction. When one pair is losing, the other is winning. 

What is Currency Correlation

In its most basic form, the currency correlation tells you whether the two currency pairs will move in the same direction, in an opposite direction, or in a totally random direction.  

The currency pair correlation uses statistical measurement to calculate the coefficient of the currency pair. This statistical measure gives you an idea regarding the strength of the relationship between the currency movements.  

The correlation is represented between the range of +1 to -1.  When the coefficient of the currency correlation is at +1 or sits near it, it means that the currency pairs are likely to move in the same direction.  

Meanwhile, the currency pairs are negatively correlated when it sits at –1 or anywhere near it. With this, you can expect the two assets to move in different directions.  

But what does it tell if the coefficient is at 0? Well, it tells you that the pairs are not correlated at all. Meaning, the assets move in a totally random direction.  

Note: Currency pair correlations are only valid for a specific period. It's important to know that it changes over time to save you from potential downfall.

How to Read Currency Correlation Coefficient

As mentioned, the degree of currency correlation depends on the measured coefficient. And hear this: coefficient values are more than just +1, 0, or –1; they can be +0.6, –0.3, or anything else between +1 and –1.  

With these diverse coefficients, new traders will probably be confused and lost with these data. Well, don't sweat; here's your reference for interpreting the currency correlation coefficient; 

For the next lesson, you'll better understand how trading currency correlations would help you become a better and more profitable trader.