How to Use Currency Correlation in Forex Trading

Discover the fascinating world of currency correlation pairs, where certain currency pairs move together while others move in opposite directions, a phenomenon that can impact your trading decisions. 

In this article, we explain what currency correlation pairs in forex are, how to use them to enhance your forex trading and which forex pairs are most closely linked. This article will provide easy-to-understand information to help you navigate currency correlations. 

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What are Currency Correlations?

Currency correlation measures the degree of similarity in movement between two currency pairs. Correlation is a standardized form of covariance and is numerically represented in a scale (correlation coefficient) ranging from -1 to +1, where -1 means that the pairs move in opposite directions (negative correlation), +1 means that they move in the same direction (positive correlation) and 0 means that they do not correlate. For example, let's suppose EUR/USD and GBP/USD have a correlation coefficient of +0.9. In that case, this value indicates a strong positive correlation.

Currency correlations can change over time due to economic events, monetary policies, market sentiment and geopolitical events. As a result, you must monitor them regularly and align your trading strategy accordingly.

What Do Correlated Forex Pairs Tell Traders?

Correlated forex pairs can tell traders a lot about the strengths and weaknesses of different currencies and economies. Suppose EUR/USD and GBP/USD are both trending upwards. In that case, it may suggest that the euro and the pound are gaining strength against the U.S. dollar. This could indicate that the European and British economies are performing better than the U.S. or that the market expects more dovish policies and lower interest rates from the Federal Reserve than from the European Central Bank and the Bank of England.

Correlated forex pairs can prompt traders to diversify their risk and avoid overexposure to a single currency. For example, if you are bullish on EUR/USD, you might want to avoid buying GBP/USD as well since they are highly correlated. Instead, look for another pair with a low or negative correlation with EUR/USD, such as USD/JPY or AUD/USD.

Since correlated pairs move in tandem, traders can predict future price movements using historical correlation patterns. If one pair experiences a rise or fall, traders can anticipate a similar action in the other pair.

Negatively correlated pairs help traders reduce currency risk by taking opposing positions. For instance, if a trader has a long position on EUR/USD and wants to reduce exposure to the U.S. dollar, they can take a short position on USD/JPY, which has a negative correlation. This offsets losses on EUR/USD if the U.S. dollar strengthens, with gains on USD/JPY.

What Do Non-Correlated Forex Pairs Tell Traders?

Non-correlated forex pairs indicate that traders should not expect similar movements in that currency pair. For example, if EUR/USD and USD/JPY have a low correlation, it means that they are affected by different drivers. The economic and political developments mainly influence EUR/USD in Europe and the U.S., while USD/JPY is mainly influenced by the risk appetite of investors and the demand for safe-haven assets.

Non-correlated forex pairs can help traders create more balanced and profitable trading strategies. For instance, if you are bearish on EUR/USD, you should hedge your position by buying USD/JPY since they have a low correlation. This way, you can reduce your exposure to the euro and increase your exposure to the U.S. dollar. To diversify portfolios, investors typically look for non-correlated assets.

Most Correlated Forex Pairs

The table below shows some of the most correlated forex pairs based on their recent daily correlation coefficients.

As you can see, some pairs have a high positive or negative correlation, while others have a low or zero correlation. You can use this information to identify trading opportunities and manage your risk.

How to Use Currency Correlations to Trade Forex

You can use currency correlations to trade forex in different ways, such as:

• Confirming trends: If two correlated pairs are moving in the same direction, it can guarantee the trend's strength and increase your confidence in your trade.

• Spotting divergences: Two correlated pairs moving in opposite directions can signal a potential reversal or a temporary correction and alert you to exit or adjust your trade.

• Hedging risk: If you have a position in one pair, you can hedge your risk by opening a position in another pair that has a low or negative correlation.

• Avoiding overexposure: If you have multiple positions in different pairs, you can check their correlations to avoid being overexposed to a single currency or direction.

To use currency correlations effectively, you need to have access to reliable sources of data and a good understanding of the factors that affect each pair. You also need to keep an eye on the correlations regularly and update your trading strategy accordingly.

Featured Brokers

If you want to trade currency correlations, you need a trading platform that offers a wide range of forex pairs, advanced charting tools and reliable execution. Here are some of the top trading platforms that we recommend for forex traders:

Mastering Currency Correlations for Enhanced Trading Performance

Currency correlations are an important concept for forex traders to help them diversify their risk and optimize their performance. However, currency correlations are not static and can change over time due to various factors. Traders must keep track of correlations and modify their trading strategy accordingly.

Frequently Asked Questions