What are some examples of currency correlation?
Forex correlation hedging strategy
Correlation allows traders to hedge positions by taking a second trade that moves in the opposite direction to the first position. A currency hedge is achieved when gains from one pair are offset by losses from another, or vice versa. This may be useful if a trader doesn’t want to exit a position but wants to offset or reduce their loss while the pair pulls back.For example, the EUR/USD and AUD/USD share a strong positive correlation in the table above at 75. Buying the EUR/USD and selling the AUD/USD creates a partial hedge. It is partial because the correlation is only 75 and correlation doesn’t account for magnitude of price movements, only direction.
In the case of the GBP/USD and EUR/GBP, there is a negative correlation. Therefore, buying or selling both creates a hedge. Buying the GBP/USD will make money if the GBP/USD goes up, but those gains will be offset by the long position on EUR/GBP falling because of the negative correlation.
Read more about forex hedging strategies.
Pairs trading
A pairs trade involves looking for two currency pairs that share a strong historical correlation, such as 80 or higher, and taking both long and short positions on the assets. A trader can buy the currency that is moving down and sell the currency pair that is moving up. The idea of this is that they will eventually start moving together again, given their long history of a high correlation. If this occurs, a profit may be realised.
However, there is a danger that the pairs don’t go back to being highly correlated. Therefore, some traders may place a stop-loss order on each position to control the loss. There is also a danger that the loss on one trade isn’t offset by a gain on the other, resulting in a loss, even if the pairs move back to their previous correlation. Ideally, the bought pair would move up and the sold position move down as the pairs mean-revert, which could result in a profit on both trades.
When using any currency correlation strategy, and any strategy, position sizing is a key component to risk management. Based on where the stop loss is placed, many traders opt to risk a small percentage of their account, for example, if the stop loss is reached. For instance, if the stop loss is 30 pips in the EUR/USD (with a USD account), taking a micro lot position means there is a risk of $3 on the trade (30 x $0.10). For that $3 of risk to be equal to only 1% of the account, the trader would need to have at least $300 in the account. This way, the risk on the trade and risk to the account is controlled.
Commodity currency correlation
Commodities or raw materials also have a correlation with each other as well as with currencies. In the table below, the data shows that during this timeframe, gold (XAU/USD) had little correlation with other major currencies. However, it does indicate that it shared a strong positive correlation of 81 with silver (XAG/USD). For someone trading gold and holding positions in other currency pairs, this type of analysis is important.
For example, it is worth noting that natural gas doesn’t share a high correlation with any currency pairs, or with precious metals like gold or silver. Meanwhile, crude oil (WTICO) also doesn’t show a high correlation to currencies, but it often does have a correlation with the USD/CAD and CAD/JPY. This is because both Canada and Japan are major oil importers.
Commodities can hedge or be hedged by currencies when there is a strong correlation present in the same way that currencies hedge each other. A commodity may move much more in percentage terms than a currency, so gains or losses in one may not be fully offset by the other. Read our commodity guides on oil trading and gold trading.
