What Is Correlation In Forex? The Role Of Correlation In Trading

Types Of Correlation

There are three types of correlation:

• Positive correlation describes markets that mimic each other's movements and move in line with each other.
• A negative correlation describes the markets with opposite movements and they move against each other.
• Zero correlation describes markets with no correlation.

Correlation Of Forex Currency Pairs

Below is a correlation coefficient table for the major forex currency pairs, which shows the degree and type of correlation of these currency pairs with each other in a period. For example, the EURUSD currency pair has the highest positive correlation of +77%. That means if the Euro/Dollar currency pair grows, there is a 77% probability that the Pound/Dollar currency pair will also rise and move in line with each other. EURUSD has a strong negative correlation with the USDCAD currency pair to a -79% extent. That is if the Euro/Dollar currency pair grows, there is a 79% chance that the USDCAD currency pair will decrease, and these two currency pairs will move in opposite directions.

You can see the correlation coefficient table of forex currency pairs in the image below.

Also, in the table above, you can see that the GBP/USD currency pair has a strong positive correlation with the GBP/JPY currency pair to the extent of +88%. In both of them, the first currency symbol is the British pound. It can be concluded that this strong positive correlation is due to the movements of the US dollar and the Japanese yen.

Which Currency Pairs Are More Correlated?

As shown in the image above, the key currency pairs with the highest correlation are EUR/USD and GBP/USD. They often have similar movements due to economic relations between European countries. In this case, GBP and EUR are closely related based on the shared geographical proximity of the Eurozone and the UK, as well as the reserve currency status. Also, the fact that both currency pairs share the dollar as a cross-currency means that any change in the dollar is reflected in both currency pairs simultaneously.

Other currency pairs that tend to show strong correlations are AUD/USD and NZD/USD currency pairs. Australia and New Zealand are also geographically, economically, and industrially very close to each other.

Currencies generally known as "Low-risk assets" (Swiss Franc and Japanese Yen) can also show a good correlation with each other.

Currencies generally known as "Commodity currencies" (Canadian, Australian, and New Zealand dollars) also show a good correlation with each other.

Why Correlations Are Important

Correlations can have a significant impact on your overall risk level and final profit, and a market move against your analysis will affect your entire portfolio. For example, if you have open sell positions in two symbols with a positive correlation of 75%, a bearish trend in one will likely lead to a similar move in the other. If a position moves against your analysis, you risk losing the capital allocated to both positions. Therefore, your total risk from the trade can be higher than you originally planned.

Your overall risk in managing the account can be much higher than you think if you have multiple correlated positions. So it's always worth checking which markets are correlated and which ones can add diversification to your portfolio.

Also, the correlation of the symbols can be helpful for technical analysis, for example, the EUR/USD currency pair crosses its main resistance in the technical analysis, but the GBP/USD currency pair is still involved with its resistance because these two currency pairs are strongly positively correlated. They can also act in the same direction in technical analysis, and this currency pair can overcome its resistance. Therefore, correlations can be used in technical analysis in addition to trading risk coverage.

Profiting From Correlations

You can also use correlations to make a profit. For example, a stock trading strategy is to find stocks of related companies and monitor their price performance.If one of the shares of these companies had an independent movement compared to the rest of the shares, you can assume that this movement is fake and take a position regarding its eventual return to normal. The same can be done in forex trading.

Commodity Correlations

Some correlations are only temporary, while others have lasted for years and are likely to continue. Here are some common examples to be aware of in your trading.

Dollar Correlation With Gold

Perhaps the most well-known financial market correlation is between the US dollar and gold. Gold is priced in US dollars, so its price is highly dependent on the currency's strength, and there is a strong negative correlation between the two. When the dollar's value rises, the gold's price often falls. As a result, in gold transactions, you should pay attention to the data related to the US dollar in the economic calendar, such as the inflation rate, interest rate, etc.

In the image below, the gold chart is orange,and the dollar index chart is blue. Gold and the dollar index have moved opposite of each other in the long term, indicating the negative correlation between gold and the dollar.