Why currency correlation is important to a trader?

 Some of the main reasons why you must know Currency correlation as a trader is to avoid double Risk exposure and hedging.

Currency correlation shows how 2 currency pairs can move in the same, opposite, or completely random directions within a particular period.

With Currency correlation, you can know which currencies move in the same direction, opposite or just random.

It also identifies the degree of to which currency pairs are correlated such as strong, moderate,  weak, or no correlation.

Let’s now look at some good reasons why you must know currency correlation as a trader,

Why you should know currency correlation as  a trader

1. Eliminating double exposure.

Here you will avoid taking multiple positions with currency pairs that are highly correlated.

Let’s say you are going long on EUR/USD and GBP/USD and then you add on USD/CHF.

First of all considering your two positions the EUR/USD and GBP/USD is like having two positions on the same pair.

In case the trade goes wrong you are exposed to a double risk so your loss is doubled.

Lucky enough, if it goes well you double your profit but we don’t play luck because anything can happen in the markets.

So you have to choose and trade one that looks best and manage your risk.

However, USD/CHF has a negative correlation with both EUR/USD and GBP/USD.  It therefore moves in the opposite direction.

This simply means as EUR/USD and GBP/USD move up, the USD/CHF goes down.

Similarly, opening new position on the USD/CHF is an additional risk too.  All this is not necessary.

Once you understand the correlation between currencies, you can avoid unneccessary risks.

2. Hedging

 When you know currency correlation between different pairs, you will be able to take in a chance to hedge against your losing trade.

This can only be done using currency pairs that are negatively correlated (Moving in different directions). As a result, you close trades with either small losses or take in a small profit.

For instance when you open a long position on USD/CHF.

In case the trade goes against you.

Take a long position on the EUR/USD. You can use the same size or smaller size depending on the volatility or size of the pip.

If not, close out the trade if it has shown signs of a failing trade to avoid losing your money for no good reason.

Although hedging can save you some profits, you can’t use it in all situations

. This is because currency movements change more often. It could stab you in the back.

3. Signals trend direction

 In this manner when your understand correlation you will be able to tell the direction and movement of some currency pairs by looking at the other.

When two pairs are highly correlated, one can serve as a leading indicator of the price movement of the other.

For example,

When one pair is showing a strong movement in its current direction, and the other is ranging.

Chances are high that it will take the same direction after the range/pause. You can easily tell its next move and direction.

Signals trend direction

For example EUR/USD and GBP/USD.

In case you short EUR/USD and you realize GBP/USD is ranging or is in congestion.

Since the two pairs move in the same direction almost 100%.

You will not risk going long on the GBP/USD unless you are 100% sure that it’s taking the opposite direction.

Alternatively, you can use strong negative correlated pairs as signal for trend reversals.

For 2 negatively correlated currency pairs,

 If you notice a significant upside price reversal on one pair, then you can anticipate a potential downside reversal in the other pair.

EUR/USD and USD/JPY

Signals trend direction

Last but not least,

Correlation can also help you to diversify the risks by holding multiple positions.

You can use currency correlation to hedge and manage risks of taking too many positions of the same currency pair.

For example you can buy some EUR/USD and also AUD/USD instead of having all positions on one pair.

 

Despite EUR/USD and AUD/USD having a strong positive correlation, the two have different pip values, spreads and volatility.

 

 

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