Defining Correlation in Finance

Correlation in finance is the statistical measure of the degree to which two securities are related to its other. This relationship is measured during a certain time period.

Correlations are expressed on a scale of -1.0 to +1.0, as follows:

■ +1.0, two assets move in an identical direction, 100% of all times 

■ +0.0, two assets move in random directions

■ -1.0, two assets move in the exact opposite direction, 100% of all times

For example EURUSD and GBPUSD have a positive correlation between +0.8 and +0.9. That means there is 85% probability that these two pairs shall trade in the same direction. If we exclude the news-trading hours, this correlation may become even stronger.


 

The Dependency of Forex Pairs

As Forex currencies are quoted in pairs, there is no individual pair completely independent from all the others. Correlations between pairs can be measured in various timeframes, but longer-term correlations (6-month or more) should be considered more reliable.

The knowledge of the basic correlations between Forex pairs is helpful because:

  • It can lead to less risk exposure in the Forex market
  • Correlations can be used for confirming any trading signal
  • Monitoring correlated Forex pairs is also helpful in determining the ‘sweet spot’ when opening or closing a trade position.

Group of Currencies

In general, there are some groups of currencies that tend to trade on the same direction. For example, this is a very strong group:

■ EURUSD, GBPUSD, AUDUSD and NZDUSD

In the chart below (source: Google-Finance) you can see graphically the correlation of these 4 pairs during the period 2008-2015. Although AUDUSD and NZDUSD have performed better there is a clear correlation in the trend direction of all pairs.

Chart: EURUSD, GBPUSD, AUDUSD and NZDUSD Correlation 2008-2015

 

This is happening as USD is used as the base currency or else as ‘money’ in the Foreign Exchange. That fact itself creates a general trend in the market, which either favors the USD and all the above pairs are moving in downtrends, or it is against the USD, and all the above pairs are moving in uptrends. Here is some proof regarding the importance of US Dollar in the Forex market.

Table: Most traded currencies by value (Source: Wikipedia)

 

CURRENCY

SYMBOL

 % VALUE PARTICIPATION

1.

United States dollar

USD

87.0%

2.

Euro

EUR

33.4%

3.

Japanese yen

JPY

23.0%

4.

British Pound sterling

GBP

11.8%


Correlations are Formed Dynamically

Some correlations between Forex pairs have a historical character, but that does not mean they are historically stable. On the contrary, new political and economic conditions may alter the correlation between two Forex pairs. This is especially true as concerns commodity currencies, such as AUD, CAD, and NZD, which show extreme sensitivity to price changes of particular commodities.  Furthermore, changes in the level of interest rates (monetary policy) can play a decisive role as concerns correlational changes.

Check live Forex pairs correlations in the below links:

» http://www.myfxbook.com/forex-market/correlation

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Historical Correlations of the Forex Majors

These are some strong historical correlations between Forex majors, and between Forex Majors and other markets:

EURUSD

EURUSD has a high positive correlation with GBPUSD and a negative correlation with USDCHF and USDJPY.

GBPUSD

GBPUSD has a high positive correlation with EURUSD and a negative correlation with USDCHF and USDJPY.

USDJPY

USDJPY is negatively correlated with EURUSD and GBPUSD. But there is also another form of correlation regarding USDJPY. As the Japanese interest rates are traditionally very low, American investors tend to borrow in JPY in order to buy US stocks. Therefore, USDJPY is considered to be negatively correlated with the US investor’s sentiment and the general political sentiment in the US.

USDCHF

The USDCHF is negatively correlated with EURUSD and GBPUSD.

USDCAD

The USDCAD is very sensitive to the changes of oil prices as the Canadian economy is a major oil-exporting economy. Moreover, USDCAD is highly negative correlated with AUDUSD and NZDUSD and less with EURUSD and GBP/USD.

AUDUSD

AUDUSD is highly and positively correlated with NZDUSD. The Australian and New Zeeland economies are very sensitive to commodity price change, and therefore, are negatively correlated with USDCAD.


Some Useful Conclusions Regarding this Forex Correlation Analysis

These could be some useful conclusions regarding correlations between Forex pairs:

  1. First of all, when you trade intraday, have always opened side by side, the charts of all important correlated pairs. If you trade GBPUSD always get advice from the current momentum of EURUSD and EURGBP.
  2. Avoid opening positions on the same side of two correlated Forex pairs because that shall increase (X2) your risk exposure in the market.
  3. Avoid opening opposite positions on highly correlated Forex pairs. Opposite position means one position ‘cancels’ the other and you will just end up paying two spreads without any result.
  4. Use correlations between pairs as a tool for confirming trades via Technical Analysis.
  5. Use correlations between Forex pairs to define the optimal entry and exit levels on your trades.
  6. Take advantage of simultaneous trading signals occurring in correlated Forex pairs. For example if you get a buy signal from RSI (14) on EURUSD M5 chart, and at the same time you have a bullish formation on GBPUSD, one signal confirms the other.
  7. When you get two signals from two correlated Forex pairs, for example, GBPUSD and USDCHF, choose to trade the pair offered in the best spread between ask and bid. If the spread size is almost the same then choose the Short-Trade, downtrends are usually stronger.
  8. If you are about to trade an automated Forex strategy on a particular pair you can apply back-test on all its correlated Forex pairs in order to confirm the results.

 

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Forex Pairs Correlations

George Protonotarios, Financial Analyst

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