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In the previous lesson, you've learned how currency correlation helps you navigate the forex market a bit easier. By trading the currency correlation, you figuratively have a cheat sheet that tells you the potential market trend.
In this lesson, you'll understand how trading currency correlation will help you trade better.
Profiting on the forex market is an exhilarating experience. However, you should know that doing it takes effort and skill.
One effective way to profit from it and limit risks is to trade currency correlation. Here's what you can expect when you use currency correlation in your trading arsenal.
Counterproductive trading means that you have two positions that cancel each other out. How do you ensure that you're not trading counterproductively?
Well, you can look at the currency correlation. By looking at the coefficient of currency pair correlation, you can see how your desired assets will move.
Assume you want to go long on EUR/USD and USD/JPY. What you can do to avoid nonsense trading is to check whether the two pairs will cancel each other out.
Simply look at the currency correlation coefficient and interpret the given value. If the value suggests that both pairs have a positive correlation, it's safe to assume your trade will not be counterproductive.
However, if the coefficient value is negative, the currency pairs will move inversely with each other. If you push through with your buying positions, you trade counterproductively.
Why? If the EUR/USD appreciates and the USD/JPY depreciates, you just offset the possible profit you're supposed to get from your EUR/USD position.
Zero loss because you offset the risk? No.
You wasted money because you paid twice the supposed spread or transaction fee.
Again, knowing the currency pair correlation gives you data on the movement of two currency pairs.
If you're confident about the upcoming market trend of two assets you want to trade, trading positive correlations will magnify your profits.
Suppose you've calculated your coefficient and found that EUR/USD and GBP/JPY are perfectly correlated. This finding gave you an idea that your prospective assets will move in the same direction.
But which direction? Should you go long or short? Well, you must analyze the market and news releases.
Analyzing the market is a prerequisite in trading and should always be used in conjunction with trading correlations.
If your market and news analysis are correct, you double your profit. However, if not, you sadly double your losses.
Remember: Currency correlation can only tell you the relationship of the currency pairs' movement. It can't tell you which direction the pairs will move.
One primary benefit of using currency correlations is you get to hedge your trade to offload market risk.
Assume your EUR/USD is losing (you open a short position, and the market appreciates). To offload the market risk and limit or offset losses, you can go short on a currency pair that negatively correlates with the EUR/USD.
Sounds great? Well, you need to know that hedging has its drawdown.
Remember that correlation changes; it may strengthen or weaken.
Suppose you hedge your losing EUR/USD with USD/CHF. Your EUR/USD position had fallen by 100 pips, but since it's negatively correlated to USD/CHF, you expect the latter's market to appreciate 100 pips.
However, the correlation weakens, and the USD/CHF only moves 25 pips in favor of your position. When this happens, you fail to offset your losses; you just limit it to a 75-pip loss.
Having the idea about currency correlation will force you to trade different currency pairs. Well, it gives you an idea about the benefits of using different currency pairs. So, it's no doubt that you'll be driven to diversify your portfolio.
Assume you're a big fan of EUR/USD. Rather than only using EUR/USD on all your trades, you know that opening a pair that's negatively correlated with EUR/USD will offset the potential market risk.
Also, you may diversify your portfolio using currency correlation because of profitable opportunities. When you trade EUR/USD and a pair that's positively correlated to it, you can magnify your profit if the market goes in your favor.