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Section 3: Currency Pairs Correlations

It is important to understand that some currency pairs are strongly correlated. Correlation indicates the strength and the direction of linear relationships between currency pairs. When one currency moves to the north a positively correlated pair will also move to the north. When a currency pair moves to the north a negatively correlated pair moves to the south, so to speak. 

Also be aware currency correlation changes over the long and short-term so make sure correlated pairs are synchronized (can be seen to be following one another negatively or positively) before using this technique. We have detailed some of the reasons for this in an earlier lesson and the impact can be seen clearly in the table below as the figures change markedly depending on the time period studied.

We at StraightForex would advise you look at the time frame for correlation that fits the length of time you will holding the position. If you plan to hold it open for a few hours than the hourly correlation is more important but if you are thinking of keeping it for a month then the weekly period becomes relevant.

Take a look at the table below 

chart

[Table 1]

This is the currency correlation table for the middle of 2007 and gives the correlations over a number of time scales. The closer the number to 1 or -1 the more correlated the currency pairs are: 

+1 Positive correlated 
-1 Negative Correlated 

For instance, the GBP/USD and the EUR/USD have a correlation coefficient of +77 over the last year, therefore, from 100 signals in your system on the EUR/USD, 77 of them could of being signaled also on the GBP/USD. 

We must stress that these figures change quickly from over a few minutes to a few months according to a huge variety of factors including economic events, political situations and resource booms. Therefore ensure you can visibly see a correlation by looking at both the relevant pairs.

We also find the chart available at Oanda: http://fxtrade.oanda.com/currencyCorrelations/index.html very useful as they change the figures on a daily basis ensuring they are relatively current.

How can this help me as a trader? 

There are times that a system could signal one trade in both, the EUR/USD and the USD/CHF (Long for the Euro and short for the Swissy because they have a very strong negative correlation). Now, take a look at the following charts. 

chart

[Chart 1] 

chart

[Chart 2] 

If you got a signal on both of these pairs, it will be very difficult to decide on which pair to take the signal (it wouldn’t make sense to take the signal on both pairs since you are likely to get the same result on both). 

Through the use of EUR/CHF we can determine which currency is relatively stronger or weaker against each other. 

chart

[Chart 3] 

So we look at the “cross” chart to see which way the currencies are moving relative to another and take the trade on the currency that appears stronger at that point. Therefore the USD/CHF if the CHF is appreciating or the EUR/USD if the EUR is winning.

We should also take into account negative correlation as if the pairs are seen to be strongly negatively correlated the positions will cancel each other out. This technique is often used in hedging to protect investors from currency fluctuations.

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