The standard measure of correlation is the correlation coefficient, a number between -1 and 1 that indicates the strength and direction of a the linear relationship. A correlation coefficient of -1 indicates that the currency pairs are perfectly negatively correlated, that is, a higher value for one pair tends to correspond to a lower value for the other. A correlation coefficient of 1 means that they are perfectly correlated, indicating a higher value for one variable tends to correspond to a higher value for the other.
This can happen when the currencies involved in each pair are different, or when the currencies involved have different economies. We introduce people to the world of trading currencies, both fiat and crypto, through our non-drowsy educational content and tools. We’re also a community of traders that support each other on our daily trading journey. Value at risk (VaR) is a tool to measure the risk of loss on a portfolio. The currency index represents the evolution of a currency relative to the entire forex. The best way to keep current on the direction and strength of your correlation pairings is to calculate them yourself.
With this knowledge of correlations in mind, let’s look at the following tables, each showing correlations between the major currency pairs (based on actual trading in the forex markets recently). It may be important to know whether the open positions in a portfolio are correlated. In this case, it is important to adjust the size of the positions in order to avoid a serious loss. You can take a position on currency correlations with financial derivatives such as CFDs and spread bets.
The gains in one may be offset by losses in the other, which is often used as a hedging strategy. Meanwhile, buying two correlated pairs may double the risk and profit potential, since both trades will result in a loss or profit. They are not fully independent since the pairs move in the same direction. To be an effective trader and understand your exposure, it is important to understand how different currency pairs move in relation to each other. Some currency pairs move in tandem with each other, while others may be polar opposites. Learning about currency correlation helps traders manage their portfolios more appropriately.
You could use the negative correlation to hedge your exposure to risk in one of the underlying currency pairs. As an example of the positive correlation between these two pairs, you could open two long positions on the EUR/USD and the GBP/USD currency pairs. If the correlation is currently present in the market and if the pairs increased in price, you could potentially increase your profit. But, if the correlation was perfectly positive, separate long positions on different pairs might help to increase your profits – or it could increase your losses if your forecasts are incorrect.
- It is clear then that correlations do change, which makes following the shift in correlations even more important.
- Correlation, in the financial world, is the statistical measure of the relationship between two securities.
- It ranges from 1 to -1, with 1 representing a perfect positive correlation and -1 representing a perfect negative correlation.
- You might think that you’re diversifying your portfolio by investing in different
pairs, but many of them have a tendency to move in the same or opposite direction to one another.
A currency hedge is achieved when gains from one pair are offset by losses from another, or vice versa. This may be useful if a trader doesn’t want to exit a position but wants to offset or reduce their loss while the pair pulls back. If a reading is below -70 and above 70, it is considered to have strong correlation, as the movements of one are largely reflected in movements of the other. Readings anywhere between -70 and 70, on the other hand, mean that the pairs are less correlated. With forex correlation coefficients near the zero mark, both pairs are showing little or no detectable relationship with one another. Positive coefficients indicate that the two currency pairs are positively correlated, meaning they generally move in the same direction.
AUD and gold
Anything in the negative range of -100 means that the pairs move nearly identically but in opposite directions, whereas, if it is above 100, it means that the pairs move nearly identically in the same direction. “Nearly identically” is an important distinction to make because correlation only looks at direction but not magnitude. For example, one pair may move up 100 pips (percentages in point) while another moves down 70 pips. Both pairs may have a very high inverse correlation, even though the size of the movement is different. Correlations can be used to hedge, diversify, leverage up positions, and keep you out of positions that might cancel each other out. Even though correlations change over time, it is not necessary to update your numbers every day; updating once every few weeks or at the very least once a month is generally a good idea.
- As an example of the positive correlation between these two pairs, you could open two long positions on the EUR/USD and the GBP/USD currency pairs.
- Some market commentators state that the reason for the correlation between the value of yen and gold is the similarity of the real interest rates for the two assets.
- A correlation of -1 implies the two currency pairs will move in the opposite direction 100% of the time.
- In the case of the GBP/USD and EUR/GBP, there is a negative correlation.
- For instance, the correlation between the EUR/USD and GBP/USD is 77, which is quite high.
The correlation coefficient highlights the similarity of the movements between two parities. The yen is also widely believed to be a safe-haven currency, and gold is known as a safe-haven asset. Because of this, investors will often move their money into yen or gold in times of economic uncertainty, or when the markets are experiencing slow growth. This often means that while the price of one unit of yen and one unit of gold might be quite different, the overall up and down movements of these two assets tend to mirror each other. Equally, you could open two short positions on these pairs if you believed that the price of one was about to fall.
The real interest rate is the rate of interest that a market participant will receive after accounting for inflation. The value of some currencies is not only correlated to the value of other currencies, but it is also correlated to the price of commodities. This is particularly true if a country is a net exporter of a particular commodity, such as crude oil or gold. As previously mentioned, this would be effective if the price of EUR/USD fell by a certain amount per point, but USD/CHF increased for a certain amount per point. In this, the gains on the USD/CHF long position would offset the losses on the EUR/USD position.
Trading currency correlations
For example, the EUR/USD and AUD/USD share a strong positive correlation in the table above at 75. It is partial because the correlation is only 75 and correlation doesn’t account for magnitude of price movements, only direction. For example, think of the data points as closing prices for each day or hour. The closing price of x (and y) is compared to the average closing price of x (and y), so a trader can enter closing and averaged values into the formula to extract how the pairs move together. To get the average requires tracking multiple closing prices in a program such as Microsoft’s Excel spreadsheet.
Learn More About Correlation
Sentiment and global economic factors are very dynamic and can even change on a daily basis. Strong correlations today might not be in line with the longer-term correlation between two currency pairs. That is why taking a look at the six-month trailing correlation is also very important. This provides a clearer perspective on the average six-month relationship between the two currency pairs, which tends to be more accurate.