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All about currency pair correlations

Currency pair correlations in the Forex market – Official Olymp Trade Blog

Direct or inverse connections can be formed between different instruments in financial markets. This phenomenon is called correlation and can be used to make trading decisions. When trading on Forex pairs, correlations should be identified and worked into your trading decisions. In this article, we discuss existing market trading systems and methods for finding currency pairs in Forex that have a positive and negative correlation.

Contents:

Interact with the underlined words and green dots to get additional details and explanations.

Three Forex correlation strategies for market trading

There are three key strategies for trading on absolutely any market:

Directional trading

This refers to strategies based on the investor’s own forecast of either the overall financial market or a particular asset. It involves analyzing market behavior and making a choice about which direction to trade in. For example, if we believe that  EUR/USD will continue to decline, we open a Down trade on the pair. With this strategy, the risks are always at a maximum and depend on the quality of the analysis.

Hedging

Instead of focusing on making profits, hedge funds protect against market risks. For example, an American company does business in Europe and makes part of its profit in euros. It is crucial for this company to protect itself against a fall in the euro against the dollar, so it can purchase put options on the  EUR/USD pair. If the  EUR/USD later falls, the company’s profits aren’t negatively affected. It’s as if the company has bought insurance in case the currency falls.

Arbitrage

Arbitrage is making risk-free returns in the market because of price inconsistencies across exchanges or bugs in the system, although nowadays it is extremely difficult to profit from pricing errors. An example is when two assets should move in the same direction but are moving in different directions for some reason, traders can make money on the fact that the prices of these assets are bound to converge again at some point. In order to determine whether arbitrage between different assets is possible and to be able to hedge losses, we need correlation.

Correlation is the relationship between two or more variables. If the correlation is strong, then an increase in one quantity will mean that the other quantity will also increase. Examples of assets with a strong correlation are oil and petrol, gold and silver, oil and the stock price of oil companies, etc.

If a correlation is weak, then the dependence of one asset on another is either weak or non-existent. For example, the stock prices of oil producers are unlikely to depend on metal prices.

There is also negative correlation — when the relationship between values is reversed. A striking example of negative correlation on Olymp Trade is the behavior of the  NASDAQ index and the  Nasdaq Reversal 2x ETF, which is specifically built to replicate the behavior of the NASDAQ index in reverse, so that contrarian traders can still profit from the decline in an asset class.

Forex currency pairs also have correlations. Let’s take a look at how they work 👀

Base currency and quote currency

You can determine which currency pairs are correlated simply by determining whether they are a base currency or a quote currency. For example, pairs where EUR is the base currency, such as  EUR/AUD, must correlate with  EUR/CAD,  EUR/CHF,  EUR/GBP and  EUR/JPY. If the US dollar is used as the quoted currency in the pair  EUR/USD, then  GBP/USD AUD/USD and   NZD/USD should all correlate with each other.

Meanwhile, there should be a negative correlation between  EUR/USD and, for example,  USD/JPY.

In reality, of course, it’s not quite that simple. The fact is that the price of a currency pair is determined by both the base currency and the quote currency. As a consequence, it is not entirely correct to compare some currency pairs. Let us take the cross rate  EUR/CAD and  EUR/CHF as an example. The base currency in both pairs is EUR, but the movements of these pairs are also determined by the Canadian and Swiss currencies, which in their turn depend on the monetary policies of Canada and Switzerland. Switzerland’s monetary policy has traditionally been ultra-conservative, as its key rate rarely changes and has remained in the negative zone for a rather long time. In Canada, on the other hand, the rate is more volatile and depends on the economic situation.

Swiss vs. Canadian interest rates – Olymp Trade
Fig. 1. Swiss and Canadian interest rates

Other cross rates, though, are better to compare. For instance,  EUR/CHF and  EUR/JPY, because Japan also has a rather conservative monetary policy.

As for  EUR/CAD, it would be more appropriate to compare it with, for instance,  EUR/AUD and  EUR/NZD because monetary policies in Canada, Australia and New Zealand are quite similar.

How to use currency pair correlation in trading

Using currency pair correlation to hedge risk

Let’s assume that we believe the  EUR/USD pair will continue to decline during the current trading day. In this case, we can open Down trades on Olymp Trade’s Forex mode. Further, let us assume that according to our money management system, the amount of our trade will be $100 with a multiplier of 200x. This means that the total amount for which we open a trade is $20,000. In accordance with our system, we allow a loss of 25% of the transaction amount, i.e., no more than $25. We can set an appropriate Stop Loss at -$25, or we can spread out this maximum loss and hedge our trade.

Our Stop Loss on Olymp Trade Forex will be set at -$10, which means that if the loss is $10 (or 10% of the trade), the trade will be closed automatically. In order to compensate for this $10 loss, we will open a rebalancing trade in Fixed Time Trades mode on  GBP/USD, which will be up for 23 hours. If the rate of return on GBP/USD is 82%, then in order to make $10, we need to open a trade for approximately $13.

The reason for this allocation is that if  EUR/USD continues to decline, we will start earning on Olymp Trade Forex. EUR/USD is correlated with  GBP/USD, which means that if  EUR/USD is declining, then  GBP/USD will also be declining. In this case, on Olymp Trade FTT, we will get a loss equal to the amount of our transaction: $13. This loss will reduce our total profit from the transaction on Olymp Trade Forex, but the purpose of hedging is to protect against risks, so we can consider such loss as an insurance fee.

If  EUR/USD starts to grow during the day and we start to incur losses in Forex, we will make a profit in FTT, because the growth of  EUR/USD will mean growth of  GBP/USD, which means a profit of 82% of the trade amount or $10. If a Stop Loss is triggered on Forex, the loss on the Forex trade will be fully compensated by the profit on an FTT trade.

Finally, the worst-case scenario for us is if  EUR/USD starts growing and a Stop Loss is triggered in Forex. However, we will also lose in FTT, for example, if  GBP/USD falls due to the UK’s poor economic results or any other reason. In that case, our maximum loss would be $23, which fits well with our money management system.

Read more: What is pairs trading?

Using currency pair correlations for arbitrage

Arbitrage is a more sophisticated approach to trading. It involves searching for market errors and bugs that periodically appear on the market. Let us, for example, consider two currencies —  EUR/CHF and  EUR/JPY. These currencies must correlate with each other. Pay attention to the chart ⬇️

EUR/JPY and EUR/CHF one-month chart – Olymp Trade
Fig. 2. EUR/JPY vs. EUR/CHF

There is a very clear correlation between  EUR/JPY and  EUR/CHF. If one currency pair is rising, the other is also rising. However, in the past few months, there has been a divergence in the behavior of these cross rates. Specifically, while  EUR/JPY was rising,  EUR/CHF was falling. There is an explanation for this: The Bank of Switzerland decided to raise its key rate, which has resulted in CHF strengthening against other currencies. Meanwhile, we should remember that this divergence in currencies’ behavior is rather an exception than a rule, which means that we can expect the pair to converge again, which will mean either a decrease in  EUR/JPY, an increase in  EUR/CHF or a combination of both. As a consequence, the optimal market behavior in this case is to open a Down deal in  EUR/JPY and at the same time, open an Up deal in  EUR/CHF. Both trades should be opened with obligatory Stop Losses.

Conclusion

Currency pair correlation can be used effectively for trading. Basically, correlation can be used to open hedging trades or to make arbitrage transactions. Now you know the important nuances and strategies that will allow you to use this effective trading tool in the financial markets. Do not forget about implementing sufficient risk management and money management, so that trading on currency correlations can become a worthy tool in your trading arsenal.

Practice your acquired knowledge with Olymp Trade. Our platform makes any trading strategy easy and guides you toward financial success. Become part of the multimillion-strong community of Olymp Trade traders today and become a force to be reckoned with on the markets.

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Risk warning: The contents of this article do not constitute investment advice, and you bear sole responsibility for your trading activity and/or trading results.