Correlation in Forex Pairs is one of the most important techniques in risk management. Currencies in forex are exchanged in pairs, and those pairs do not behave in isolation. There are so many factors that affect a currency pair’s prices, one of those factors is its correlation with another currency pair.
The term currency correlation means the relationship two currency pairs have with each other. Measuring what relation a pair has with another is crucial to understand for forex investors otherwise they might not be able to make correct trading choices. There could be two types of relations, two currency pairs can have:
Positive Correlation: When two pairs move in the same direction, for example, if the prices of EUR/USD increases then the prices of GBP/USD will also increase due to their positive correlation.
Negative Correlation: When two pairs move in opposite directions, for example, if the prices of EUR/JPY will increase, the prices of USD/CHF will fall due to their negative correlation.
There are pairs that have no relation among them and act randomly which is called having zero correlation. These changes happened due to many factors that affect the prices of all currency pairs either positively or negatively depending on the currencies involved and the event.
Benefits of Correlation in Forex Pairs:
Here are some benefits that you will get if you can statistically measure the relation of your currency pairs.
- It can help you avoid fakeouts in price movements of currency pairs. When you notice a significant movement in the price of one currency pair, you can confirm if it’s a real move or a fake move by monitoring the movements of other currency pairs in relation to that one. If they act according to their correlation, then the move is real, and if not then it is probably a fakeout.
- You can also confirm price breakouts with the same strategy and make the most out of that trade.
- Knowing the correlation of two pairs will help in opening profitable positions rather than canceling positions. If two currency pairs have a negative correlation then opening a selling position for both of them will cause you to lose in one trade for sure, because one’s price will move up when the other’s goes down.
- It will reduce your risk exposure by diversifying the portfolio. Trading with only one pair will expose you to higher risks, instead if you trade with multiple pairs keeping in mind their correlation then you will reduce your risk. If you have multiple small trades open instead of one large one your risks are way less as for one trade if you lose, you lose all and for multiple trades you might lose some and win some, making you lose a lot less than before.
Using correlation is an important strategy for risk management. You can reduce your chances of losses if you know how each currency pair will move in relation to others, you will be able to decide better when to enter trades, exit trades, and what position to open.