With over $6 trillion in daily volume, the forex market offers tremendous opportunity for traders. However, the interconnectedness of currency pairs also presents risks that must be managed. By understanding forex pair correlations and building robust trading strategies, traders using online brokers like HFM can profit consistently.
In this article
Analyzing Currency Pair Correlations
Before putting on any forex trades, it’s critical to analyze the correlations between pairs. While some pairs tend to move in tandem, others may diverge or even move in opposite directions. For instance, EUR/USD and GBP/USD are positively correlated, meaning they generally trend in the same direction. This is because the economies of the Eurozone and UK are closely tied. On the other hand, USD/JPY and EUR/USD are negatively correlated as their economies have less overlap.
To quantify forex pair correlations, traders can use tools like correlation coefficients. Correlation coefficients range from -1 to 1, with higher positive coefficients indicating stronger positive correlation between two currency pairs.
Managing Correlated Pairs in Forex Trading Strategies
Once currency pair interdependencies are understood, traders can build more resilient forex trading strategies. For correlated pairs like EUR/USD and GBP/USD, traders may want to avoid having overlapping long or short positions. Holding both long EUR/USD and long GBP/USD leaves a trader vulnerable to general Dollar strengthening whereas negatively correlated pairs can be traded together to hedge risks. For example, going long USD/JPY while short EUR/USD would diversify exposure away from general Euro or Dollar moves. The gains on one pair may offset any losses on the other.
Utilizing Cross Pairs
Another way traders can benefit from forex pair correlations is by analyzing cross pairs. Cross pairs are derived by taking ratios of non-USD major pairs. For example, the ratio of EUR/GBP is derived from the EUR/USD and GBP/USD exchange rates. Following cross pairs provides further insight into relative currency strength. Since EUR and GBP are positively correlated, EUR/GBP will generally be range-bound. Any excessive deviations in EUR/GBP could signal upcoming reversals in EUR/USD or GBP/USD. Traders can take advantage of mean-reversion in cross pairs as correlation relationships periodically break down.
Managing Positions Amid Correlation Breakdowns
While currency correlations tend to persist long-term, they do fluctuate in the short run. During periods of market stress, correlations can break down entirely. For example, EUR/USD and GBP/USD diverged sharply following the Brexit referendum. When correlations break down, forex traders must manage open positions carefully. Widening correlations mean diversification benefits are lost. Traders should reduce overall position sizes and not overexpose themselves in one direction. Hedging with opposing trades in uncorrelated pairs can also offset drawdowns.
Implementing Stops on Correlated Pairs
Given fluctuating correlations, traders should consider using wide stops on correlated pair trades. For instance, if going long EUR/USD with a stop at 1.1500, also implement a stop on any long GBP/USD position well before its usual stop. This will prevent correlated pairs from being stopped out together in a reversal.
In forex trading, no currency trades in isolation. Analyzing forex pair correlations enables traders to maximizes profits while minimizing risks. By diversifying positions across uncorrelated pairs, managing position sizing, and using wide stops, traders can build resilient forex trading strategies. Even as currency correlations evolve, traders can adapt and thrive.
