What is Forex Pairs Correlations Trading?
By Paul Choufani, Updated on: Apr 07 2023.
Forex pairs correlation trading involves trading with forex pairs using the correlation variable between different currency pairs. The strength of the relationship between the forex pairs in question would be used as one factor in determining the orders and/or trades taken on the pairs in question by the trader.
Imagine, for example, the case of a retail trader, operating on a forex brokerage platform. He intends to place a long trade on GBPUSD, during the opening of the London trading session. The decision to implement this long trade is based on forex technical analysis conducted by the trader. To the surprise of the trader, for some reason the trade wouldn’t execute, and he suddenly remembers an email sent to him from the brokerage a couple of days before, stating that trading for the GBPUSD would be suspended this morning, due to some technical issue.
He then decides to conduct a quick study on a similar pair, GBPJPY, and decides to place a similar long trade. The reason he chose this pair is because of the relatively high correlation between GBPUSD and GBPJPY, as they tend to move in the same direction on London session openings, more often than not. This is because of the common denominator of the GBP currency in both pairs, in addition to the volatility of the JPY currency during an active afternoon session in Tokyo. The trader is aware of this, and it isn’t long before the GBPJPY pair actually rises in value, indicating that the trade is now running at a profit. The trader happily closes the trade, as he is content with the profit made based on his understanding of the positive correlation between the GBPUSD and GBPJPY pairs.
What is correlation in forex trading?
Correlation in forex trading is a measure of the relationship between two or more currency pairs, in terms of their behaviour and price action. Essentially, it is a reflection of the degree of the dependence of one currency pair on the movement of the other. Correlations between pairs are present in several cases, and which include both technical and fundamental factors.
Sometimes, there is correlation due to the forex pairs having similar base currencies (eg. GBPUSD and GBPJPY). At other times, they represent closely-linked economies (eg. EURUSD and GBPUSD or AUDUSD and NZDUSD). There are also cases like the EURUSD and USDCHF duo, with each currency moving in opposite direction to one another. This is due to the US dollar being the quote currency in the former pair and acting as the base currency in the latter, while the European and Swiss economies and heavily intertwined, thus resulting in the currencies moving together.
There are numerous examples of correlations existing between different currency pairs. Sometimes, the correlation is high between both pairs, while at other times the correlation is low, reflecting a minimal or even non-existent degree of dependency between the currency pairs in question.
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Currency correlation coefficient
The coefficient for currency correlation is the numerical measure of the relationship and interdependency between two different forex pairs. The range of the coefficient is -1 to 1, or -100% to 100%.
Perfect positive correlation is represented by the coefficient 1, or 100%. This means that there is a high degree of impact of the movement of one pair on the movement of the other pair, and both pairs move in the same direction.
Perfect negative correlation is represented by the coefficient -1, or -100%. This means that there is a high degree of impact of the movement of one pair on the movement of the other pair, but both pairs move in the opposite direction.
If the correlation coefficient is close to 0, or 0%, then there is little impact of the movement of a specific currency pair on the movement of a different currency pair. If the coefficient is in fact 0 (or 0%), then both currency pairs are perfectly independent from each other, with no impact of one's price movements on the other's price movements.
The closer the coefficient is to 1 (100%) or -1 (-100%), the stronger the price dependency and relationship between them; they would move in a similar direction if the coefficient is positive, and in opposite directions if the coefficient is negative.
Examples of forex pairs with different levels of correlation
Among the set of forex pairs in the market, different pairs exhibit differing levels of correlation in the market, for technical and fundamental reasons, or a combination of both. We will look at examples of forex pairs with varying levels of correlation with each other.
Positive correlation
It is common knowledge that the EURUSD and GBPUSD pairs are highly positively correlated with each other, the coefficient being relatively close to 1. This is due to several factors, such as the similarity of monetary policy between the Bank of England and the European Central Bank, as well as the interdependency and close links shared by the economies of the UK and continental Europe. Furthermore, the EUR and GBP currencies are among the most liquid in the world after the US dollar, which is a factor in their respective high market volatilities versus the USD, the quote currency and common denominator between both pairs.
The same reasoning and logic is used to explain the high positive correlation between the AUDUSD and NZDUSD currency pairs. Both Australia and New Zealand have strong economic ties and similar monetary policies. AUD and NZD are both influenced by commodity prices in the same way, and both currencies tend to appreciate versus the dollar when the investor risk appetite is high.
Negative correlation
A famous example of high negative correlation exists between the EURUSD and the USDCHF currency pairs, with the coefficient being relatively close to -1. The USD is the quote currency in the EURUSD pair, while serving as the base currency in the USDCHF pair. The USD moving in a certain direction already has opposing impact on the movements of each pair. Furthermore, the EUR and CHF currencies tend to behave very similarly in the market, due to the close, inextricable ties between Switzerland and the European Union, with the Swiss National Bank particularly cautious from monetary policy divergence from the EU.
Negative correlation also exists between the GBPUSD and EURGBP pairs, with the British Pound acting as the base currency in the former pair and as the quote currency in the latter pair. A GBP appreciation during a London morning session would raise the price of the GBPUSD pair during a quiet US market, while having a decreasing effect on the EURGBP price.
Minimal correlation
There are pairs with little or no correlation with each other, and that is perfectly common. The countries or economic zones pertaining to the pairs in question, have little to no economic ties with each other, and tend to get influenced by other, more significant political or economic factors at play. For example, if we account for the currency pairs AUDNZD and EURGBP, we see that they move independently from reach other. There are no common fundamental or technical factors impacting their price movements. The correlation between the pairs is close to zero.
Using correlations in trading forex
Traders generally factor in correlations between currency pairs while making decisions in trading forex. Of course, there are other factors which experienced traders account for, such as technical and fundamental analysis, as well as emotional and risk management. Yet, there are scenarios and cases where utilizing correlations in the trading approach is an effective strategy for the trader to pursue.
Hedging
Hedging in forex is a strategy used for risk management purposes while trading. If a trader wishes to hedge an existing position, he/she could place a second trade in order to manage the risk from the initial position and protect initial capital or profit margins. For example, if a trader has an initial long position on AUDUSD, he/she can decide to implement a short position on NZDUSD, which would serve as a hedge against the initial long position, reducing its risk exposure. The highly positive correlation between AUDUSD and NZDUSD would imply a price move in the similar direction for both, which means that long and short positions for the pairs would decrease the risk present in the overall position.
Market exposure increase
On the other hand, the trader may seek to increase his/her market exposure through placing similar trades on both AUDUSD and NZDUSD pairs, due to their high positive correlation. In doing so, he/she would increase the market exposure in the position through both pairs. The upside is that more profits can be captured if the trades go in the desired direction, but the downside is significant if the trades go in the opposite direction. The high positive correlation between AUDUSD and NZDUSD would imply a price move in the similar direction for both, which means that similar positions for the pairs would increase the risk associated in the overall position.
Diversification
Trading using the correlation factor could be a means towards diversifying risk as well. For example, if we consider the GBPUSD and AUDUSD pairs in our scenario, the trader can seek towards placing long trades on both pairs, should he/she believe that they will both appreciate in value. He/she can divide the weight of the overall position into both trades, instead of assigning the whole weight of the position on a long trade for only GBPUSD, for example. This is because although both pairs are positively correlated, it isn't at a perfect or maximum correlation level. If one pair were to move in one direction, the other pair were to move in the same direction, but not by the same magnitude.
Forex correlation with commodities
In addition to the significant correlated relationships among a large number of forex pairs, there also exists similar correlations between some currencies and commodities. For example, there exists a positive correlation between the Canadian dollar (CAD) and crude oil, since Canada is an important oil producing country, with its oil exports boosting its economy. So when oil rises in price, it tends to cheapen the US dollar, while causing an appreciation in the Canadian dollar. This presents an important opportunity to short the USDCAD forex pair.
Similarly, there exists a positive correlation between the Australian dollar and gold, due to Australia being a renowned gold exporter. An increase in the gold price has a bullish impact on the AUDUSD currency pair, while a drop in the gold price causes a decrease in the AUDUSD pair.
Are currency correlations always the same?
Currency correlations are not constant and are subject to change based on several factors, including technical and fundamental considerations. For example, not so long ago, the JPY currency was considered a safe haven during uncertain times when investors tended to be risk-averse. This does not seem to be the case today. During the course of 2022, important currency pairs such as USDJPY, EURJPY and GBPJPY appreciated in price, which reflected a lack of investors buying or holding the Japanese Yen.
Furthermore, there are other factors, both political, financial and economic, which impact currency correlations. These could include fiscal or monetary policy shifts as well as other cyclical factors. So if, for example, an financial institution was to enact a large forex swing trade, it would need to be cognizant of both current and prospective correlation levels for the currency pairs in question.
Conclusion
Overall, currency correlations are a significant factor traders use in their trading activities, in addition to technical and fundamental analysis, as well as emotional and risk management practices. Both positive and negative correlations between different currency pairs provide useful insight into the behaviour of different pairs, reflected in the price action of one pair when the other pair moves in a certain direction. Traders should be mindful on the strategy they decide, whether it is to hedge, diversify risk or to increase market exposure. In the latter tactic, they would need to manage risk carefully to ensure protection of initial capital or previously-captured profits.
Frequently Asked Questions
Which forex pairs are highly correlated?
AUDUSD and NZDUSD have high positive correlation with one another, as do EURUSD and GBPUSD. Two pairs with the highest negative correlation are EURUSD and USDCHF.
Should you trade correlated currency pairs?
It is advisable to understand the correlation involved between the pairs in order to trade them, bearing in mind the necessary technical considerations and risk management practices.
Which forex pairs have no correlation?
Currency pairs which move independently of each other and have no financial, political or economic relationship between each other. EURNZD and GBPJPY are one example. Another example is AUDNZD and EURGBP.