Professional traders know that there are a lot of factors to consider when it comes to building a thorough trading strategy. One of these factors is the degree of correlation between various currencies. Today we are looking into some of the most popular currency pair correlation trading strategies and how to effectively apply them.
Currency Pairs Correlation Meaning
For a beginner trader it may seem like all currencies of the world are going their own way. Because simple logic suggests that if all pairs moved alike, their values are going to be the same. However, the price movement is more of a symptom than a cause. Which means that there are a lot of components in the mix of Forex prices, and, what’s more, they all have connections among each other and some are even capable of affecting the movement throughout the entire market.
Which brings us to the initial point: comprehending all impactful factors and using them in your trading process is a tremendous asset. The currency pairs correlation strategy Forex, for instance, suggests that betting on the currencies that agree with each other can serve as a magnifying tool and bring your profits to a new level. But before we go into the technicalities of correlation-based trading, let’s first discuss the ways to track the relationship between your chosen currencies.
Expert traders are capable of going on about the ways currency pairs affect each other for hours. Fundamental analysis of the market tells us that every particular currency has a foundation to stand on and that foundation consists of many contributing elements. Without a doubt, the longer you spend on Forex, the better you will need to understand how each part of the mechanism works. But at the very beginning, there is no need to dig too deep.
The main tool for correlated pairs Forex strategy is correlation matrix. It is an interactive range that features all traded currencies and the degree of correlation between each of them. There are two important things to remember about the way this matrix operates: one, the numbers are calculated through a preset formula that looks at how average values of considered currency pairs compare. And two, the matrix is always changing, just as the price values do. So in order to effectively implement any Forex correlation pairs strategy, you will have to refer to the matrix on a regular basis.
Trading Strategies Using Inverse Correlations
There are several approaches on using correlation in trading. The first one is somewhat intuitive: when two pairs are correlated it means that when one goes up, another does as well. So, if a trader opens a long position in both pairs, the result profit has a great chance of being doubled. An additional perk of this approach is diversification, through which a trader can slightly reduce the overall risk and still keep the focus on a specific direction.
Another approach is Forex pairs trading strategies using inverse correlations. When you look at the correlation matrix, you will notice that the range goes from 1.0 to -1.0, translated to percentage it will be 100% to -100% or entirely correlated and not correlated at all, respectively. Some brokers will also color code the matrix to go from intense green to intense red, to make it easier to read.
So, when we look at the pairs that range below zero, we will see the ones that are close to being fully non related, such as EUR/USD and USD/CHF. Opening a long position in both pairs simultaneously can be a good solution to reduce volatility-based risk exposure in one of the pairs. When one of the pairs goes from trending up into a downward movement, wait for the non related pair to counter progress and cancel out any caused loss. This way, although you are not gaining more than expected, you are losing significantly less or nothing at all.
When you choose a currency pairs correlation strategy Forex, consider several pair combinations before you go in. Your success may be affected by the angle with which the correlation varies, so remember to check back with the matrix or even learn how to calculate correlation by yourself. The bottom line is, every Forex pair correlation strategy in Forex is just as effective as any other approach. It is your job to consider all underlying ups and downs and come up with your very own way of applying the trading method in action.