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How Do You Trade Currency Correlation?
Today’s topic: currency correlation.
Did you know that currency pairs sometimes move together?
Knowing this can kick-start your forex trading career!
For example, if a US dollar forex pair moves in a certain manner, it’s likely more US dollar pairs would follow suit and you could profit from the move.
We call this currency correlation.
Let’s dive into the detail…
Currency Correlation: The basics
I believe that all things are connected.
It may seem strange talking about nature in a forex course. But we need to start somewhere! Everyone knows that each ecosystem is dependent on another in nature. For example, bee pollination is essential to plants reproducing. In turn, plants help sustain the food system by feeding animals and humans.
It’s similar in economics and forex ― everything is connected.
During the coronavirus panic of 2020, where the stock market crashed by roughly 40%, China was the first to lockdown its economy. When coronavirus spread to the rest of the world, other countries followed suit and the stock market crashed.
Most currency pairs fell sharply against the US dollar during coronavirus.
That’s positive correlation.
In terms of explaining correlation, let’s make it simple. If the cost of A increases, as well as the cost of B, this is called positive correlation. But if the cost of A increases at the same time that the cost of B decreases, this is called negative or inverse correlation. The below chart shows an example of inverse correlation:
When a forex pair has opposite trends to another, that’s called negative correlation. Note: The currency correlation won’t always be a mirror image, which we will explain below.
Positive and negative currency correlation
In statistics, correlations are given measurements.
Positive correlations have a scale from 0 to 1. This represents how close the correlation is between two markets. Negative correlations have a scale from 0 to -1. This represents the different movements between markets; as one moves up, the other goes down.
The greater the correlation value, the greater the correlation between the two markets. For example, 1 and -1 are perfect correlations. You don’t find perfect correlations often. You will find currency pairs can have perfect correlations at times. Those that do will have a strong positive or negative correlation most of the time.
Digging deeper into currency correlation
Forex correlations are mostly observed regionally (i.e. Southeast Asia).
If certain currencies in a region (i.e. Indonesia) see a sudden currency drop, other currencies within the region (i.e. Thailand) tend to also be affected. Therefore, unless you have a good reason, I don’t recommend trading two or more cross/exotic pairs of the same currency.
That tip should reduce risk.
Let’s say Joe sees a positive correlation for the Mexican peso. He decides to only trade one MXN currency pair, until he’s proven right. Joe doesn’t want to take on any more risk, such as trading the MXN/CAD. If his trade starts to work out, Joe will put on the second trade. But if it doesn’t, he won’t lose any more money.
Forex traders like to see the currency correlation between markets. For example:
You can compare the list to your trading charts later.
Practical trading examples
For now, imagine a big corporation needs to hedge its Aussie dollar position. Hedging is going short (betting that prices will fall) a market to potentially reduce risk. For example, we know that Australia is a commodities-producing country. So if the corporation tried to hedge its Aussie dollar exposure shorting Canadian dollars, how do you think that would work out?
Canada is also a commodities-producing economy.
In fact, the Canadian dollar and the Aussie dollar are pretty much positively correlated. So if you tried to hedge your Aussie dollar exposure with Canadian dollars, it would probably be a disaster!
I’d want to hedge my forex exposure with a negatively correlating currency.
On the other hand, if we want to find trading opportunities, we’re likely to look to positively correlating currencies that tend to move together. Some educators will disagree with us. But they don’t know what they don’t know! The easiest way to make money is buying similar currencies that go up or down together.
For example, since we know that everything is connected, imagine there’s an emerging market crisis starting to happen and the Thai baht plummets. What are you going to short next? The US dollar or the Mexican peso?
If you said the Mexican peso, congratulations.
The US dollar is the world reserve currency ― not an emerging market currency.
See, forex trading isn’t that hard! Unfortunately, many people just dive right into forex trading. Newbies don’t bother learning how to become a successful trader. The best way to start making money trading forex is understanding currency correlation.
Your ‘Start With Forex’ takeaway: Currency Correlation
To become an elite trader, it’s important to know how different currency pairs move in relation to one another. So if you’re new to forex trading, look for simple currency correlations around the world.
Learning about currency correlation also helps manage risk.
For example, if you were going to hedge a currency, you would look for negatively correlating pairs. If you want to find a trading opportunity, look for pairs with positive correlation. Professional traders tend to target one forex pair at a time. If you find a positive correlation to the current target, you should jump into the forex trade.
But never put too much weight on a single trade or numerous trades! Correlation values change all the time, since news happens 24/7.
I hope you saw some value in this short lesson. But there’s still so much for you to learn. In the next lesson, we’ll take things up a level. If you’re ready to learn about the best forex strategy, click here.
To your trading success,
Start With Forex
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