Currency pairs are interrelated in the forex markets. As a forex trader, understand that the price action of each currency pair is not independent of other.
Most pairs move relative to one another. Understanding that different currency pairs are correlated is important for you. These correlation numbers can be positive or negative.
Knowledge of how strong this relationship is and its direction can help you in developing your trading strategies with a new perspective. This has the potential to become a great trading tool for you.
Correlations are numbers ranging between +1 and -1 that are calculated based on past pricing data between different currency pairs. These numbers can provide you with information that can maximize your trading returns, minimize risk and help avoid counter productive trading.
Lets use an example to make it clear. Suppose USDJPY and USDCHF has a positive correlation of +0.83 last month. This number is close to +1. It indicates that both pairs move together most of the time in the same direction.
Now, if you are trading USDJPY and USDCHF at the same time, it will double up your position if you take long positions or short positions on both at the same time. If you lose a trade on USDJPY, the chances are that you will also lose the trade on USDCHF 83% of the times.
Lets take another example to elaborate more. EURUSD and USDCHF both have a negative correlation of -0.92 in the last month. Both the pairs are moving in opposite directions recently. If you take long position on EURUSD, it is not a good strategy to take short position on USDCHF. It will only double up your position with increased risk.
When investing in two pairs at the same time, try to choose such pairs that have correlations close to zero. This will make the two pairs almost independent of each other and you can invest in both of them safely.
Always keep this in mind that currency markets are constantly changing. The correlation between currency pairs also keep on changing. It would be a good idea to calculate the correlations between pairs on a monthly basis.
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