What is Currency Correlation?
Currency correlations help trade multiple currencies in the forex market by identifying the market trends of each currency pair. It also provides traders with opportunities to amplify their profits and hedge the forex positions by opening similar or opposite orders, respectively. In this article, take a look at currency correlations in-depth.
What is currency correlation in forex?
A forex correlation refers to the relationship between two different currency pairs–which can either be positive or negative.
When two currency pairs have a positive correlation, they are positively impacted by each other and move in the same direction. For example, one of the most correlated currency pairs in the forex market is EUR/USD vs GBP/USD. If you open a long trade in both these currency pairs, a positive movement can potentially double your profits, but a fall can also potentially double the risks as well.
When two currency pairs have a negative correlation, they are negatively impacted by each other and move in the opposite direction. A positive movement in one currency pair leads to a negative movement in the other currency pair and vice versa. This is why negatively correlated currency pairs can be used as a hedging strategy as a loss in one currency pair can be offset by profits in the other. An example of negative correlation is EUR/USD vs USD/CHF. If you open a long position in EUR/USD but the markets fall, you can quickly open a short position in USD/CHF to hedge the risk.
Non-correlated currency pairs
These pairs have no relationship with one another and do not affect each other’s movement. An example of non-correlated currency pairs is EUR/USD and GBP/NZD.
What is the correlation coefficient?
Correlations can be strong, weak or non-existing. A correlation coefficient helps in determining if the correlation between the two currency pairs is strong or weak, and to what extent. In forex, the value of the correlation coefficient ranges from -100 to 100.
- When the value of a correlation coefficient is in the -100 range, it indicates that the currency pairs move almost identically in the opposite direction.
- When the value of a correlation coefficient is in the 100 range, it indicates that the currency pairs move identically but in the same direction.
- When two currency pairs move in the same range, that is, for example, below -50 and above 50, it means that they have a strong negative correlation.
- If both the currency pairs move above 50, they are said to have a strong positive correlation.
- If a currency pair moves below -70 but above 20, the two are said to have a negative correlation, but the strength of the correlation is weak.
- When a currency pair moves above 20 and the other moves above 80, they are again positively correlated, but the strength of the correlation is again weak as they move in the same direction but in a different range.
How to trade on currency pair correlations in forex?
Currency correlations can be traded in forex by identifying all currency pairs that have a positive, negative and no correlation to one another.
- When you identify two or more currency pairs having a positive correlation, you can open the same position in all of them.
- When you identify currency pairs with a negative correlation, you open two opposite positions.
- Identifying currency pairs with no correlation gives you a free hand in opening a long or short order as per your preference.
When you open two long positions in a positively correlated currency pair, the separate positions help you increase your profits as they move in your favour. However, opening the same long or short position in two currency pairs that are negatively correlated to each other cancels each other out as when one moves in your favour reaping you profits, the other moves against you, cancelling those profits. That is why it is recommended to always open opposing positions in negatively correlated currency pairs. You can open different positions in correlated currency pairs to diversify your forex portfolio and protect yourself against market risks. When a single currency pair moves against you, having positions in correlated pairs helps you either cancel out the losses or actually profit from the opposite movement. For example, assuming that you are trading USD/CHF and EUR/USD together that are negatively correlated to each other. You open a long position worth 10 euros in EUR/USD and simultaneously open a short position worth 8 euros in USD/CHF. If EUR/USD falls to 2 euros, you make a loss of 8 euros in total. However, the fall in EUR/USD results in the increasing price of USD/ CHF, which rises to 15 euros. This reaps you a total profit of 7 euros. Hence, opening two opposite positions in the negatively correlated currency pair actually results in you making a loss of only 1 euro, which would not have been possible had you not traded correlated currency pairs.
What are the most highly correlated currency pairs?
EUR/USD vs GBP/USD
EUR/USD vs GBP/USD has a very strong positive correlation that ranges between 0.81 and 0.95 (81% to 95%), implying that any increase in EUR/USD will definitely lead to an increase in GBP/USD exchange rates as well and vice versa. These two currency pairs are highly correlated because there is a very close relationship between the UK’s GBP and the European currency Euro. They are both one of the most vastly held reserve currencies, and their close geographic proximity and strong trade relations affect their economies almost the same way.
GBP/USD vs EUR/JPY
GBP/USD vs EUR/JPY has a strong positive correlation that ranges between 0.88 to 0.94 (88% to 94%). The positive correlation between the two pairs stands due to the already discussed positive correlation between GBP and EUR, along with the strong and close trade relationship between Japan (JPY) and America (USD). Japan is also one of America’s closest and oldest allies, and the countries view each other favourably.
EUR/JPY vs USD/JPY
EUR/JPY vs USD/JPY also has a positive, strong correlation that ranges between 0.86 and 0.98 (86% to 98%). This positive correlation exists between these two currency pairs due to their strong political relations and alliance between them. Europe and America are also one of the biggest economies in the world, having strong economic relations with dominating military power, making the two economies positively correlate to each other as a decision by one economy is usually followed by the other.
AUD/USD vs NZD/USD
AUD/USD vs NZD/USD is the last most highly and positively correlated pair that ranges between 0.86 and 0.99 (86% to 99%). They are highly and positively correlated because Australia and New Zealand hold one of the strongest ally relationships with each other in the world economy. Not only are they in close geographical proximity, their trade, defence, and migration ties are strong, making them positively correlated. The two countries also have a very strong people-to-people link, making the relationship between the two countries and their currencies powerful.
EUR/USD vs USD/CHF
EUR/USD vs USD/CHF is one of the most highly and negatively correlated currency pairs that ranges between -0.85 to -1 (-85% to -100%), implying that any increase in EUR/USD will definitely lead to a decrease in USD/CHF’s currency exchange rate and vice versa. The two pairs are negatively correlated mainly because of Europe's divergent monetary and political policies as a whole and Switzerland as an independent country. In most cases, any uncertainty affecting Europe does not have a considerable impact on Switzerland and vice versa due to the different processes and procedures followed by both regions.
EUR/USD vs USD/CAD
EUR/USD vs USD/CAD is also strongly and negatively correlated between -0.72 and -0.98 (-72% and 98%). They are negatively correlated due to the USD being a quote currency in the first pair and a base currency in the second pair. Since Europe and Canada have a very strong, friendly and strategic relationship with each other, any increase in USD’s price decreases EUR/USD but increases USD/CAD as more Euro is then required to purchase a single unit of USD, but less Canadian dollars are needed for the same.
AUD/USD vs USD/CHF
AUD/USD vs USD/CHF is the last highly inversely correlated pair that ranges between -0.78 to -0.99 (-78% to -99%). The inverse relation between the two pairs is due to the US currency being in the quote currency place in the first currency pair and in the base currency place in the second one. Hence, any positive movement in the USD marks a negative movement in AUD/USD but a positive movement in USD/CHF. This inverse relationship is also affected due to the positive economic and political relations shared by Switzerland and Australia, along with their strong diplomatic relations.
Can commodities be correlated with currencies?
The currency pairs are not only correlated with each other but with several commodities like oil, gold and more. Currencies are correlated with commodity trading when a particular country is a prominent net exporter or importer of the commodity. Any change in that currency’s exchange rate or commodity prices affects one another. One of the highest correlated currencies with commodities are the Australian Dollar, the US Dollar, the Swiss Franc, the Canadian Dollar, the Japanese Yen and the Euro.
- The Australian Dollar is strongly and positively correlated with the prices of precious metals like gold, copper and silver since Australia is one of the highest producers of these metals.
- The US dollar is inversely correlated with most commodities, especially oil since all commodities are quoted in the US dollar. Hence, when the US dollar is strong, one needs a lesser amount of the US dollars to buy the commodity and vice versa.
- The Swiss Franc has a strong positive correlation with gold since 1/4th of Switzerland’s total money supply is guaranteed through gold reserves.
- Since Canada is one of the biggest net exporters of oil, it holds a strong positive correlation with the commodity.
- Japan is one of the biggest net importers of oil and hence has a strong inverse correlation with the commodity.
- As Euro is the closest alternative to the USD and the second-largest traded currency after the US dollar, it holds a positive correlation with oil and precious metals like gold.
Currency correlation formula
R = Σ (X- x̄) (Y- Ȳ) / under root of (Σ [(X- x̄)(X- x̄)]) * under root of (Σ [(Y- x Ȳ)(Y- Ȳ)]) Where, R = correlation coefficient X = first currency in the currency pair Y = second currency in the currency pair x̄ = average of all the variable X observations Ȳ = average of all the variable Y observations
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