Using Forex Correlation Effectively

In order to be an effective Forex trader, you need to understand how different Forex currency pairs move in relation to each other by studying their correlation. There are a many reasons why this is significant, but probably the most important is that this information will allow you to understand and control your risk exposure better. For example, possessing a portfolio that comprises the EURUSD and NZDUSD contains different risk elements than one containing the EURUSD and USDCHF. If you held both long EURUSD and USDCHF exposures, then these transactions would generally lead to zero profits or even losses because when the EURUSD rallies, the USDCHF will conversely sell off in most cases.

Furthermore, correlations shift with time. For example, although the EURUSD and GBPUSD may have had a strong positive correlation for the 6 months to 1 year, this relationship could then begin to deteriorate. Shifts, such as these, can be partially explained by changes in the severity of monetary policy or changes in other domestic economic conditions of one or both applicable countries. For example, the UK could have had a sharp amendment to its monetary policy that would increase the probability of lower interest rates prompting traders to reduce their pound exposure. Such an action would then directly affect the correlation of the GBPUSD and EURUSD pairs. Understanding this knowledge will enable you to more effectively diversify and manage your portfolio.

Regardless about whether you are looking to diversify your positions or find alternate pairs to leverage your trading portfolio, you must understand that it is very important for you to keep in mind the correlation between various Forex currency pairs and their shifting Forex trends. Over the past few years, traders have become accustomed to the idea that the day-to-day moves in stocks impact currencies. When equities sell off aggressively, the U.S. dollar usually strengthens across the board as investors pile into the low yielding safe haven currency. When equities stage a strong rally, on the other hand, the dollar tends to sell off as risk appetite increases.

So, in summary, correlation analysis compares currencies by determining similarities of their movements. A high negative correlation provides a strong indication that two currency pairs will move in the opposite direction. As a result, your potential for profit could be severely compromised should you trade two currency pairs with this characteristic. Alternately, a high positive correlation value implies that the two relevant currency pairs should move in the same direction providing you with optimum chances of achieving profits from both.

Understanding the concepts about correlation should certainly help you increase your chances of Forex success.