Use of Forex Correlation Coefficients
When putting it in numbers, a currency pairs' correlation can be indicate in a figure ranging from -1 to 1. The financial meaning of which is to demonstrate the relationship between two assets. If the correlation is 1, it means that two currency pairs move in the same direction all the time. If the correlation value is -1, then there is a negative dependence: the movement of such a currency pair is 100% predetermined and has the opposite direction. The correlation of currency pairs with a value of 0 implies that their behavior is completely unrelated to each other.
Use of correlation coefficient can protect you from making many unwise decisions such as opening positions in the same directions for currencies, which have negative correlation. For example, the correlation of EUR/USD and USD/CHF currency pairs is close to -1, which means that almost all the time when the value of one pair rises, the price of the second pair decreases. That is why long trade of EUR/USD and the same trade of USD/CHF are almost meaningless.
In practice, a sharp rally of the first trade will be balanced by the sale of the second one. There is another option as well, for example a long trade of EUR/USD and the same long trade of EUR/JPY, will result in almost a doubling of your positions, due to the strong correlation between those two pairs.
Forex Correlation Reduces Risks
The use of correlation coefficients also allows you to reduce risks with the help of diversification. For example let’s take EUR/USD and EUR/JPY. Correlation coefficient for those two pairs is positive, but is not equal to 1. That is why, the use of those two pairs will be an excellent opportunity to increase your profits. Especially, in the case that the price acts as forecasted, but it will make less losses when the price act the other way. If a trader expects euro to rise, then it would be more logical to buy one lot of EUR/USD and one lot of EUR/JPY, then simply buying 2 lots of EUR/USD.
In any case, it doesn’t matter which strategy a trader is using, it is important to keep in mind correlation interaction. Change in correlation coefficient can provide you with the necessary information to diversify risks, find alternatives and hedge. This ultimately will have a positive impact on income.
To conclude, there are three possible ways to use correlations:
Avoid opening same direction positions for currencies with highly negative correlation index.
Avoid opening different direction position for currencies with highly positive correlation index.
Use correlation to diversify risks.