What is correlation? Correlation is a statistical measure of how two variables are related. In Forex trading,
correlation is a measure of how two currency pairs are related.
I'm sure that sometimes you have noticed that two currency pairs seem to go in the same direction.
This is called positive correlation.
Sometimes currency pairs seem to go in the opposite direction.
This is called negative correlation.
The correlation coefficient ranges between -1 and +1. With +1,
we have a perfect positive correlation.
This means that the currency pairs move exactly in the same direction all the time. With -1,
we have a perfect negative correlation, which means that the currency pairs move in the opposite direction
all the time.
Let's have an example. Dollar against Swiss Franc and Dollar against Canadian Dollar have a correlation
coefficient of 0.31. What can we say about it?
It is a positive correlation but not too strong.
So these two currency purchases sometimes have the same movements but it doesn't happen often.
To understand better how correlation works.
It is important to analyze single currencies and not in a pair.
So we have pound, United States dollar and euro. The strongest one, at the moment, is the pound.
The second one is the United States dollar and last one is euro, which is very weak at the moment.
What if we open a long position on pound-dollar and a short position on euro-dollar? Many traders
will tell you that it doesn't make sense because these two currency pairs have a strong correlation.
It is hard that you will have a profit from both of your positions.
If you have a look at the list, the pound is gaining against the United States dollar, because it
is stronger.
The United States dollar is weaker than the pound but it is stronger than the euro.
A long position on pound-dollar and a short position on euro-dollar would be both profitable
in this case.
Of course the best option for you in this scenario would be a long position on pound-euro or a
short position on euro-pound, if you prefer.
It is exactly the same. If we check a correlation chart, like this one
on OANDA, we can see that there is a strong correlation between euro-dollar and pound-dollar.
One hour and one day don't count for now, because I'm recording this video on a Sunday so they are 0
and 1,
but, if you check all the others, you can see that there is a strong correlation between them.
This can be explained, once again, looking at the single currencies,
instead of considering them in a pair. Euro-dollar and pound-dollar have both the dollar in common.
This means that if the dollar is very weak, probably Euro and Pound will both gain against the dollar.
If the dollar is very strong, Euro and Pound will both lose against the dollar.
This leads us to my first advice: avoid to trade correlated currency pairs in days with important
news,
if the news is about the currency that is in common in both of your potential trades.
If there is an important news for the United States dollar, like the non-farm payrolls for example,
you can be sure that the dollar will drive the market.
So the correlation will get stronger.
So if you are thinking to open position or Euro-dollar and pound-dollar on the day of the non-farm
payrolls, it is probably not a good idea.
Another important thing to consider is the time horizon for your trade. Usually correlation is not so
important if you plan to close your trade in minutes or hours.
It becomes more important if you are planning to keep your trade open for days or weeks.
Here we have two charts: euro-dollar on the left and pound-dollar on the right.
Both of them have a five minute timeframe.
You can see that even if you can find some similarities in these two charts,
euro-dollar is going up forming higher lows. Pound-dollar seems not to have a clear trend at the
moment and anyway it is forming lower lows, so just the opposite of euro-dollar.
If we increase the timeframe like four hours, we can see that it is very easy to find a correlation
between these two currency pairs.
Movements are very similar and, in general, the market seems to follow the same direction.
So the final question is: should you open trades with currency pairs that have a strong correlation?
The answer is: it depends.
If you have important news during the day that can affect the currency pair that is in both your trades,
maybe it is better to trade just one currency pair.
If you are planning to keep your trade for several days or several weeks, then, once again, probably it
is better to open just one trade or another solution could be to split the risk between those two currency
pairs.
If it is not one of the cases that I have mentioned, I think that correlation is a bit overrated and
I honestly don't really mind about it that much.