Forex Correlation Pairs: What Are They And How To Use Them?

Forex Correlation Pairs What Are They And How To Use Them

If you have been in the FX industry for quite some time, you must have noticed that when one currency pair rises, another one falls. Again, when some currencies fall and another seems to follow the lead and fall as well. 

This is what currency correlation is. 

Understanding Forex correlation pairs is no rocket science. Instead, this is simple financial mathematics, and you will understand better if you notice the price charts. 

For now, we are here to save your back. Wondering about what currency pairs are? Let’s get right into it!

What Are Correlation Pairs In Forex Trading?

When talking about foreign exchange trade, “correlation pairs” describe the connection between two currencies’ values. How closely these pairings’ movements match each other is what we mean when we talk about correlation. 

If the two sets of numbers are positively correlated, then their movements are parallel; if they are negatively correlated, then their movements are anti-parallel. 

To explain the point, if the EUR/USD and GBP/USD are positively correlated, then an increase in the EUR/USD is likely to be accompanied by a rise in the GBP/USD. When the EUR/USD rises, the USD/JPY is likely to fall if the two currencies have a negative correlation.

Traders must comprehend these relationships. To maximize your potential gains, you might, for instance, purchase both the EUR/USD and the GBP/USD if you anticipate that they will climb together. 

Hedging using pairs that are negatively linked is another option. Since the fluctuations of USD/JPY are inverse, purchasing USD/JPY helps reduce potential losses if you are uncertain about the EUR/USD rising. 

However, inaccurate predictions might result in larger losses, therefore this tactic necessitates exact understanding.

Correlations between currencies might fluctuate in strength during the day. The US market hours see the most volume in currency pairs trading against the dollar, whilst the European market hours see the highest volume in currency pairs trading against the euro or the pound. 

Currency Pairs That Usually Go In The Same Way 

  • EUR/USD and NZD/USD
  • USD/CHF and USD/JPY
  • EUR/USD and GBP/USD
  • EUR/USD and AUD/USD
  • AUD/USD and NZD/USD

Currency Pairs That Usually Go In The Opposite Way 

  • USD/CAD and AUD/USD
  • USD/JPY and AUD/USD
  • EUR/USD and USD/CHF
  • GBP/USD and USD/JPY
  • GBP/USD and USD/CHF

Correlation Coefficient

The degree of association between two currency pairings is measured by the correlation coefficient. Variations from -1 to +1 are possible. 

The data points can be categorized as relationship statuses, such as “It’s complicated,” “Just friends,” or “Soulmates.”

When two currency pairings have a perfect positive correlation (+1), their movements are constantly in sync. They are constantly moving in opposing directions. Also, they have a negative correlation of -1. 

The couples will move at random and independently if the correlation is 0. We don’t know how the movements of one pair will influence the other.

You need to understand it’s not certain that there must be a casual relationship between two things just because they move in tandem. For example, roosters may crow in the hours leading up to sunrise, but that doesn’t actually make the sun come up. 

Types Of Currency Correlation

For your convenience, here are some types of currency pair correlation and their strategies.

Forex Correlation Hedging Strategy

Traders can make use of currency correlation to their advantage by forex hedging their bets with a second trade that swings in the opposite direction. Take the 75% positive correlation between the EUR/USD and the AUD/USD pairs as an example. 

You can buy EUR/USD and sell AUD/USD to build a partial hedge. This indicates that you stand to gain from an increase in the EUR/USD exchange rate, but stand to lose from a decrease in the AUD/USD exchange rate. 

There is also a negative link between the GBP/USD and the EUR/GBP. Thus, in that case, the trader stands to win from a strengthening GBP/USD pair but stands to lose from a weakening EUR/GBP one. 

By hedging against possible losses while remaining in the market, this approach lessens the effect of negative moves in one pair relative to gains in the other. 

Currency Correlation For Commodities 

There are also links between currencies and commodities such as crude oil, gold, and silver. Take the 81% positive correlation between gold (XAU/USD) and silver (XAG/USD) as an example. 

So, it’s not uncommon for silver prices to move up in tandem with gold prices. Investors who have gold and silver holdings might use this correlation to their advantage when trying to forecast market moves. 

As an example, the USD/CAD and CAD/JPY pairs tend to be correlated with crude oil prices. Since oil is a key export commodity for Canada, changes in oil prices can have an effect on the value of the Canadian dollar. 

Trading Pairs

The goal of pairs trading is to take opposing positions in two currency pairs that have a high degree of historical connection, usually 80% or more. 

A trader may choose to purchase EUR/USD and sell GBP/USD if the two pairs deviate from their typical pattern; this would be the case, for instance, if the two pairs share a high correlation. Therefore, the trader hopes to make a profit when the pairs converge, which will happen when they move back in sync.

But there are dangers to this approach. It is possible that the pairs will not return to their historical correlation, which could result in losses. Traders typically employ stop-loss orders to cap losses on each position in order to reduce this risk. 

Calculating Correlations Yourself

Calculating currency correlations yourself is a simple way to stay updated on the relationships between different pairs. By using software like Microsoft Excel, you can easily compute correlations for a large amount of data. 

Excel’s correlation function, =CORREL(), makes this process straightforward. You can download historical daily currency prices from charting packages, including some free ones, and import them into Excel. 

By analyzing one-year, six-month, three-month, and one-month trailing readings, you get a comprehensive view of how the correlations change over time. Thus, it helps you make better trading decisions based on current data.

Here’s how to calculate the correlation step-by-step in Excel:

  • Get the pricing data for your two currency pairs, like GBP/USD and USD/JPY.
  • Create two columns in Excel, each labeled with one of the pairs.
  • Fill the columns with previous daily prices for each pair through the analyzed time frame.
  • Now, type =CORREL( at the end of any column.
  • Highlight all the data in that column to get a range of cells in the formula box.
  • Type a comma to separate the ranges.
  • Repeat steps 4-5 for the other currency pair’s data.
  • Close the formula to look like =CORREL(A1:A50, B1:B50) and press Enter.

The result that you find indicates the correlation between the two pairs. Thus, updating your correlations every few weeks or at least once a month is recommended, as correlations change over time. 

How To Trade Forex Correlation Pairs?

Now that you understand all the details about currency correlation pairs, why not dive deeper and learn how to use them? Follow the following tips: 

Sign Up For A Live Or Practice Account

Join a broker’s live trading platform to begin trading Forex correlations. Another option is to use a demo account to practice with virtual dollars. This way, you may test out the trading platform and its features even without investing your money on the line.  

Investigate The Foreign Exchange Market

Studying currency pairs and the variables that affect them will give you a solid grounding in the foreign exchange market. Interest and inflation rates, among other economic indicators, play a crucial role. 

Also, gaining a grasp of these factors enables you to anticipate changes in currency values and spot possible trading opportunities.  

Choose A Method For Correlating Currencies

Hedging, pairs trading, and commodity correlations are a few strategies that can help you take advantage of currency correlations. So, include your trading objectives, risk tolerance, and preferred methods in this document. 

You can avoid letting your emotions get in the way of your discipline and attention when you have a well-defined plan.

Implement Risk Management Strategies

Look at stop-loss and take-profit orders, which are risk management tools. These systems automate the closing of positions at predefined price levels, which helps reduce risk in volatile markets. 

Find Correlated Currency Pairs  

Determine if there is a positive or negative connection between the given currency pairs. Pairs are positively correlated if they move in the same way and negatively correlated when they move in opposite directions. 

You can make smart trades if you know these connections. For instance, you can increase your gains or losses by initiating positions on pairs with a positive correlation.

Make Active Hedging

Use correlated pairs to reduce risk in active transactions. The long-term negative correlation between the USD/CHF and EUR/USD pairs makes it possible to hedge a long-term long-USD/EUR position. 

This approach lessens the likelihood of possible losses. Gains from one pair might mitigate losses from the other, lowering total risk, if one pair moves adversely.

Why Is Currency Correlation Important?

As it has such a profound effect on total risk and portfolio performance, traders must have a firm grasp of Forex currency correlation. The direction of movement in one market relative to another can be seen through correlations. Here are some things why we consider it important for traders.

Potential To Reduce Risks 

Because of their potential to alleviate risk, currency correlations play an essential role in risk management. As an example, if you have investments in two markets that are highly correlated, a decline in one market will probably have a comparable impact on the other. Unwanted losses may come due to this. 

In contrast, hedging opportunities might be presented by negative correlations, where a gain in one position can offset a loss in another. 

Profit Making 

By hoping for things to get back to normal, traders can profit from divergence in connected assets. If two currencies that typically move in tandem experience a divergence, a trader could place a wager on their re-convergence. 

To be successful with this tactic, you need to keep an eye on price fluctuations and correlation trends. 

Gains From Diversification

Gaining knowledge about FX correlation also helps with diversification. Determining the type of connection determines whether holding investments in correlated currencies might decrease or raise risk. 

One way to diversify your portfolio while keeping a similar market outlook is to trade non-perfectly correlated currencies, such as EUR/USD and AUD/USD. 

Hedging Approaches

You can protect yourself from losses by hedging utilizing FX correlation trading. Because of the negative correlation between the two currencies, it is possible to lower risk by maintaining short positions in both the EUR/USD and the USD/CHF. 

The rise of EUR/USD could lead to a loss, but the gain of USD/CHF could more than makeup for it. Despite the fact that this approach has a lower profit potential, it considerably lowers risk. 

Forex Correlation Table

The following tables illustrate the correlation between some of the different currencies of the foreign exchange market.

Forex Correlation Table

Which Forex Pairs Are Most Correlated?

Usually, currencies that have the closest economic ties become highly correlated currency pairs. As an example, you can take EUR/USD and GBP/USD, as they are often positively correlated. The following are the top correlated currency pairs. 

GBP/USD vs USD/CAD = -88% correlated

GBP/USD vs USD/CHF = -93% correlated

EUR/USD vs USD/CHF = -91% correlated

AUD/USD vs NZD/USD = 87% correlated

EUR/USD vs GBP/USD = 89% correlated

Bottom Line 

Understanding Forex currency pairs gives you a good grasp of the market and trade fruitfully. With real-time understanding, you can make the best out of the knowledge in your trading. 

However, these correlations are not a constant factor. So, you need to consider some other things while making a trading action. 

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