Currency correlation meaning in forex is how currency pairs tend to behave in the same way or different from one another.
If you are a trader, i suppose you have already noticed that. If not, give it some time and try to follow up movements of some currency pairs on the market charts.
You will notice a difference in their movement.
You will notice that when a certain currency pair rises, another currency pair rises to. Or when it falls another currency pair rises.
In other wards, some pairs tend to move in the same direction, the others go in the opposite direction while the others just move randomly.
When the currency pairs are moving in the same direction or opposite directions, it indicates some kind of relationship.
This kind of relationship is Correlation.
What is currency correlation?
Correlation is the measure of the relationship between variables
So, currency correlation Is a statistical measure of how currency pairs move in relation to each other.
Currency correlation shows currency pairs that move in the same direction, opposite or completely independent of each other (move randomly).
Since currencies are traded in pairs, in one way or the other, they depend on each other.
This happens because some countries share the same geographical area & so are affected by the same economical factors.
For instance, interdependent economies are commonly affected by the same factors.
When there is a drop or rise in one’s economy, it affects the currency of a relative economy. The effect is either positive or negative.
Let’s look at Canada and the U.S.A.
The two countries highly dependent on each other and are economically competitive.
A fall or rise in US Dollar will have a great effect on the Canadian Dollar.
Alternatively, in a currency pair, when the base currency’s economy is stronger than the quote currency,price rises.
The opposite is true.
Correlation between currency pairs
If different currency pairs share the same base or qoute currency, they are almost likely to move in the same direction.
Some of the examples of currency pairs sharing the same base currency.
We have; USD/CAD, USD/JPY,USD/CHF or GBP/CAD,GBP/JPY,GBP/USD or EUR/CAD, EUR/JPY, EUR/JPY.
Currencies that share the same quote currency;
EUR/USD, GBP/USD, NZD/USD,AUD/USD or CAD/JPY, CHF/JPY,GBP/JPY,EUR/JPY,AUD/JPY, NZD/JPY, CAD/JPY to mention but a few
On the other hand,
If the two currency pairs have nothing in common, almost 100%, they will move randomly.
Examples include; EUR/USD and GBP/CHF or USD/CAD and NZD/JPY or AUD/USD and EUR/CHF.
However, if the base currency of a currency pair is the quote currency of the other pair, the two pairs will move in different directions.
For example, EUR/USD and USD/JPY, USD/CAD and CAD/JPY, AUD/USD and USD/CAD to mention but a few.
As a Forex trader you need to take note of this kind of relationship between currency pairs.
This is one of the ways to minimize the risks and maximize your chances of profiting trading different pairs.
When you Trade multiple currency pairs that are highly correlated, you may expose your account to a higher risk.
Last but not least, correlation between different currency pairs varies and may some times change over time. It can vary from strong, medium to weak currency pair correlation
Correlation coefficient
This is a statistical measure used to measure the relationship between variables (correlation).
It is represented numerically on a scale between +1 and -1.
Where;
- (-1) represents negative correlation coefficient.
- (+1) represents positive correlation coefficient.
- And (0) no correlation.
Positive correlation coefficient (+1), implies that two currency pairs will move in the same direction almost 100% all the time.
Negative correlation coefficient (-1), implies two currency pairs will move in opposite directions almost 100% all the time
However, the Zero Correlation coefficient implies that the relationship between the currency pairs is neutral. The movement between the two pairs completely random. No relationship, each currency is independent of the other.
Strong & Weak currency correlation
A strong positive correlation shows 0.99 and the weak correlation ranges below 0.5.
Similarly, a strong negative correlation shows -0.99 and the weak negative correlation range below -0.5.
Take a look at the picture below.
Pairs with a positive correlation move in the same direction. Conversely, pairs with negative correlation move in opposite direction.
Opening multiple positions with pairs that are highly correlated is like sitting at the edge of a sharp knife.
No matter how careful you may get, it can cut you any time things get wrong.
In this case, it exposes your account to a double risk in case the price doesn’t go as expected.
For matters of risk management, knowing how two different currency pairs move, you can avoid double risk exposure.
In the next lesson, we’ll discuss the double risk exposure in detail and also how to apply currency correlation in forex trading!
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