The notion of correlation
The currency correlation is one of the important concepts of Forex, which should have in its Arsenal every trader who trades both currency and other financial instruments. What is the correlation between currency pairs and other financial instruments? In essence, correlation is the relationship between different assets, in which a change in the dynamics of one affects the state of the other.
This relationship in the Forex market is measured by the so-called correlation coefficient, whose values are in the range from -1 to +1 (-1; -0,9; -0,8; … -0.5; … 0; … +0.5; … +0,8; +0,9; +1). The minus one indicator means the opposite, mirror movement of two assets, and the plus one coefficient implies the movement of assets in the same direction at the same time.
The coefficient 0 is the absence of any correlation, and therefore there is no relationship between the movement of the assets in question. Intermediate values of the coefficient, which are in the range from + 0.1 to +0.9, mean that trading instruments “go” not 100% the same, and the closer the coefficient is to zero, the smaller the relationship. Similarly, the intermediate coefficients between -0.1 and -0.9 mean that the strong inverse relationship of the movement decreases from -0.9 and is reduced to a slight relationship at -0.1.
Correlation depending on the direction can be of two types:
- Positive. Along with the first currency, the other currency increases in price and Vice versa in the case of a bearish trend;
- Negative. When asset 1 increases in the price of asset 2 falls and Vice versa.
The intensity of the relationship is indicated by the correlation coefficient, which can take values from -1 to 1. Yes, the relationship may be incomplete, and this is most often the case.
We must say that this indicator is constantly changing. For example, before the ruble’s dependence on oil was much greater, and therefore each decrease in the value of black gold led to a fall in the price of the ruble. But if the Central Bank provides many measures aimed at keeping the ruble exchange rate, it will not react so quickly, and may also reduce the degree of relationship between assets.
Strategies based on currency pair correlation
There are many ways to apply correlation in the currency market. You should be able to create your trading system that best fits the market situation. We will look at the most common strategies based on the correlation of currency pairs, which you will need to further adapt to yourself and the asset that you are trading.
A strategy based on the delay in changing the price of a single correlating asset. We need first to find a currency pair that has a strong correlation, and then wait until it weakens. After that, we sell a strong currency and buy a weak one, and then wait for the moment when the correlation will recover.
Hedging of positions
Hedging is a risk insurance tool. To reduce potential losses on correlated assets, follow these instructions:
- We are looking for two assets that correlate well with each other. The type of relationship (direct or inverse correlation) does not matter. Suppose this is a USD/RUB currency pair;
- A deal is opened in the direction of the trend;
- Do not forget about setting a stop loss. The limiter should be set at a level above a significant maximum;
- Open a pending transaction for oil (or any other correlating asset). The direction of the open position depends on the type of correlation and the current trend. In our case, let’s assume that the ruble is strengthening, and therefore it is necessary to sell the dollar. Therefore, we need to open a bearish trade. Pending order should be placed just below a significant minimum.
Transactions on correlated assets should be opened in the same timeframe. Do not forget about the need to set a stop loss on a pending order, because the risks can be even in the most effective strategy. Both the first position and the second must be opened for the same amount. We’ll have to arm ourselves with a calculator and count. Some brokers allow you to open transactions not by volume, but by the number of invested funds.
So, we have done everything necessary to hedge the transaction based on correlation. If the ruble suddenly starts to get cheaper, a pending order will be opened automatically. It is also not prohibited to conclude transactions in the reverse order. That is first oil, and a pending order to put on the pair “dollar-ruble.”
Correlation is a fairly effective tool for trading in financial markets. Do not forget that you need to trade only on your strategies that have been tested on a demo account or tester. The trading systems described above have been given only as an example and to indicate the basic principles of trading that you should convert to your situation.
Don’t forget about the fundamental analysis. Certain economic reasons always cause correlation, and their analysis allows you to predict the behavior of assets even before the desired market situation occurs.