Lesson 9: Correlation

Correlation in Forex

Correlation in ForexAfter we saw in the previous article the Basics of Technical Analysis, let's see now another concept, the correlation. Correlation is defined as the ratio of price developments of two markets. We will talk of correlated markets when to the increase of the first market we have an increase in the other one and vice versa, to a descent of the first market corresponds a descent of the second one and this most of the time.

The correlation coefficient is a measure that determines the degree to which two markets' movements are associated. The range of values for the correlation coefficient is -1.0 to 1.0. If a calculated correlation is greater than 1.0 or less than -1.0, a mistake has been made. A correlation of -1.0 indicates a perfect negative correlation, while a correlation of 1.0 indicates a perfect positive correlation. 0.0 means that the two markets have no correlation, they are totally independent of each other.

When we speak of correlation between currencies, we refer to the movement of two currency pairs, which can be the same, opposite or random, considered in a certain period of time. Since currencies are always exchanged in pairs, it is not possible for a currency to move on its own.


Are the correlations important?

It depends, in Forex no. Indeed, correlations are very often harmful, and I will explain the reasons. First of all, the correlations come and go. It means that today two currency pairs can be correlated, but tomorrow they may not be. Looking at the correlations between different time-frames, we sometimes see very different values, precisely because they are not stable.

Therefore, setting a strategy based on the degree of correlation between the different currency pairs, it is likely that suddenly that correlation that intercourse the currency pairs ceases; and the worst thing is that we will realise it only when we are making a loss, without having the opportunity to modify the trade first.

"If Eur-Usd will rise, then Gbp-Usd will rise as well". Probable but it is not sure because when you create a currency pair, you do nothing but oppose two economies, and the Eurozone economy is very different from the English one. Already it is not easy to evaluate two economies well, if then for chasing a correlation you put a third in it, the analysis is a lot harder.

A something like "if we know the correlations, we can cover ourselves in case of loss" is totally wrong. The most stupid thing to do if you are long on Eur-Usd is to cover yourself by selling Usd-Chf. You might as well close the position because in the positive case the loss is kept steady, in the negative one it increases because the correlation does not work.

The best thing if you want to protect your portfolio is to use​ Safe Haven Currencies and that you will see in the next article.

The same goes for the diversification of the portfolio. "Instead of investing $ 20,000 on a long operation on Aud-Usd we can invest $ 10,000 on the long of Aud-Usd and $ 10,000 on the long of Nzd-Usd". It is not always a good strategy concerning what I said above. The Australian and New Zealand economies are similar but different in some respects, such as, for example, the monetary policy. There are better ways to diversify a Forex portfolio.

The essential correlations that every Forex trader must know are those between currencies and commodities. Some economies are mainly based on the export of commodities. The currencies of these countries are called​ Commodity Currencies. The currencies that belong to this category most traded are CAD (Canadian Dollar), AUD (Australian Dollar), and NZD (New Zealand Dollar).

You will see better also the Commodity Currencies in one of the next articles.

I complete the chapter by saying that I do not use correlations between currencies in my trading, but everyone is free to think differently. For those interested, in the​ Myfxbook website, you can find the correlation table. You can select the time-frame and currency pairs of interest for you. You can verify yourself that passing from 1 day to 1 week and to 1 month the correlation values change, also a lot.

Next week we will see, as said, the Safe Haven Currencies.


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