Know Currency Correlations
Currency pairs are interrelated in the forex markets. As a forex trader, understand that the price action of each currency pair is not independent of other.
Different currency pairs move relative to one another. You need to understand that different currency pairs are correlated. Correlation can be positive or negative.
Knowledge of how strong this relationship is and its direction can help you in developing your trading strategies with a new perspective. This has the potential to become a great trading tool for you.
Correlations are numbers that range between +1 and -1. These numbers are calculated based on past pricing data between different currency pairs. They can provide you with information that can maximize returns, minimize risk and avoid counter productive trading.
Lets take an example. Suppose USD/JPY and USD/CHF had a positive correlation of +0.83. This number is close to +1. It means that both the pair move together most of the time.
Now, if you are trading USDJPY and USDCHF at the same time, it will double up your position if you take long positions or short positions on both at the same time. If you lose a trade on USDJPY, the chances are that you will also lose the trade on USDCHF 83% of the times.
Take another example. Suppose EUR/USD and USD/CHF have a negative correlation of -0.9 in the past month. Both the pairs are moving in opposite directions. If you go long on one, it is not a good strategy to go short on the other. It will only double up your position and increase your risk.
If you are investing in two currency pairs simultaneously, try choosing such pairs that have correlations near zero. Zero correlation means the two pairs are independent of each other in price action.
Keep this in mind that forex markets are constantly changing. These correlation numbers also keep on changing. It is a good idea to calculate the correlations of the pairs that you invest in on monthly basis.
