Currency correlation tells us about this interrelationship between two currency pairs. To be an effective trader, understanding your entire portfolio's sensitivity to market volatility is important because currencies are priced in pairs, no single pair trades completely independent of the others. Once you are aware of these correlations and how they change you can use them control your overall portfolio's exposure. Currency correlations measure how closely currency pair prices have (statistically) moved together in the past.
While trading in forex market it is very important to understand and keep track of currency correlations, especially if we trade with multiple currency pairs. Some currency pairs tend to move in the same direction while some in the opposite direction. There would also be some pairs which are neutral to each other. How one "currency pair" moves in relation to any other "currency pair" is identified as the correlation between those two currency pairs.
It is important to note that currency correlations can change over time because of changes in monetary policies or shifts in the eco-political landscape. Understanding how currency pairs tend to move relative one to another can be used in a number of different ways. It can be used to analyze how diversified your forex portfolio is and indirectly, your risk profile. It can also be used to understand how to enter into hedging trades.
Whenever you trade forex you must comprehend that you are in reality, buying and selling a combination of two currency pairs. These pairs consist of two currencies and its price is determined by dividing the value of one by that of the other. Once again, you must realize that you are actually generating two trades whenever you back a currency pair. For instance, if you trade the EURUSD long, you are purchasing the euro and selling the USD.
Positive and negative correlations between any currency pairs are due to the interdependence of economies. For example, the British economy or the Swiss economy would be more influenced by the developments in the European Monetary Union. This means that the British pound or Swiss franc would tend to weaken when the euro is getting weaker or vice versa. Positively correlated currency pairs are those that tend to move in the same direction most of the time, and negatively correlated pairs are those that tend to move in the opposite direction.
