The currencies traded with Forex are dynamic; they are continuously moving and changing. The trends they seem to be dedicated to following today are quite possibly not going to look the same tomorrow.
Forex correlation is something that every trader will come across at some time or other when they start venturing deeper into the trade and it is important that they understand how to interpret it.
When one pair of currencies rises and another takes a dip, or when the currency pairs begin to fall, another currency pair follows the trend and also begins losing its steam, this movement is, quite basically, what we call Forex Correlation.
Focusing on how the two currencies move in relation to one another is something that Forex traders can greatly benefit from. It can help traders develop a pattern of how the currencies move over a specific period of time. Sometimes they will move the same, other times they will move in the opposite of one another and then there are those times when the movement direction is completely random, for no particular reason.
All markets are subject to volatility, and as such are subject to completely change the direction you thought they were travelling in.
If you are reading this, you already know that Forex currencies are always traded in pairs, and unless you are only going to be trading one pair at a time, it is vitally important that you know how to read and understand Forex correlation.
Currencies are interdependent and while this relationship is what makes Forex trading possible. But because they are interdependent, the relationship and the industry can be quite complicated and complex, especially for those just starting out.
This complexity of correlating currencies also adds a risk element, and the movement of the correlation compared to the currencies you are trading can either increase your risk or reduce it. The more you know about the currencies you are working with, the better prepared you will be to make those necessary risk adjustments each time a currency moves.
Getting Technical
Traders rely on something called a correlation coefficient. And it is a little bit technical, so hold onto your seat and read what we are about to say very carefully.
Correlation coefficients are the result of the correlation which is computed into a range that extends from between -1 to +1.
The +1 is called a positive correlation. In fact, it is a perfect positive correlation. What it implies is that the 2 currency pairs are going to 100% of the time, move in the same direction.
A completely negative correlation is reflected by the -1, and this means the pairs are going to move in the opposite direction, all of the time.
When the correlation sits at 0 it means the currency pair movements have absolutely no correlation and so they are independent of each other, or completely random. This means that no trader, no matter how experienced they are, will know how these pairs are going to move. And naturally, this means there is more risk involved.
Currency Correlation Tables
Forex traders are in an incredibly fortunate position as they have access to so much data, especially if they are making use of the latest, advanced software.
Most Forex software and data is displayed on a graph of some sort. Generally, the candlestick graph is the most preferred, but there are also line graphs and charts available, depending on what type of data you are looking for.
To determine correlation, traders look for Currency Correlation Tables.
If you are someone who easily reads visual data, you’ll find a Currency Correlation Table incredibly easy to read and understand. They are made to be quite simple, but the data they provide is absolutely perfect for what you will need.
Keeping in mind the currency correlation coefficient, the table will display positives and negatives. Positives won’t have a + next to them, but the negatives will have a minus symbol, to help you tell the two of the apart.
Some tables will also have colour coding. The negatives will be in red when they are completely perfect negatives, and as the negatives move more towards the positives, the red will turn into orange and then into a lighter shade of orange. As the currency correlation moves into the positive, it will be displayed in a light green and eventually, as it moves into a complete positive, it will turn into a dark green.
Many traders will prefer to calculate the correlations themselves and it is not as difficult as it would seem. You could use a Microsoft Excel document, and then import the applicable data from a charting programme. These types of programmes will provide you with a history of daily currency prices and to get the most accurate information, you should track 1 year, 6 months, 3 months and 1 month. This will give you a deep look at the similarities and differences in the movement of the currencies over these time periods.
You can then follow these steps:
- Obtain the pricing of your pairs
- Create two columns and label them after the pairs. You then fill the columns with the data of past prices, according to the applicable time frames
- In a bottom empty cell of one of the columns add =CORREL(
- Then highlight the data (cells) in a pricing column
- Add a comma to mark a new cell
- You then repeat these steps for your other currency columns
- You then need to close the formula you have created in step 3. It will look like =CORREL(A1:A100,B1:B100)
- The number that is the result of the formula will be the correlation of your two currencies
Practice makes perfect. Go online and see how others are creating their tables, and then apply them to your own until you have it all worked out.
Correlations can be used to your advantage especially as they will help you to create and manage your portfolio more effectively. If you are keen on diversifying your portfolio, or if you want to give yourself an advantage by finding new, profitable pairs, this is the way to go.
Frequently Asked Questions
What is forex correlation?
View the comprehensive Forex correlation guide for beginners by SA Shares here
What are the most correlated currency pairs?
GBP/USD AUD/USD & EUR/USD
How do traders determine Forex correlation?
By making use of a Currency Correlation table.
What are the 7 Major currency pairs?
EUR/USD USD/JPY / GBP/USD / USD/CHF / AUD/USD / USD/CAD / NZD/USD
Can you trade forex at night?
Yes, 24hrs a day.
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