What is correlation in forex trading?
A foreign exchange correlation is the connection between two currency pairs. There is a positive correlation when two pairs move in the same direction, a negative correlation when they move in opposite directions, and no correlation if the pairs move randomly with no detectable relationship. A negative correlation can also be called an inverse correlation.
Currency correlation is important for traders to understand because it can have a direct impact on forex trading results, often without the trader’s awareness.
As an example, assume that a trader buys two different currency pairs that are negatively correlated. The gains in one may be offset by losses in the other, which is often used as a hedging strategy. Meanwhile, buying two correlated pairs may double the risk and profit potential, since both trades will result in a loss or profit. They are not fully independent since the pairs move in the same direction.
What is the correlation coefficient?
A correlation coefficient represents how strong or weak a correlation is between two forex pairs. Correlation coefficients are expressed in values and can range from -100 to 100, or -1 to 1, with the decimal representing the coefficient.
Anything in the negative range of -100 means that the pairs move nearly identically but in opposite directions, whereas, if it is above 100, it means that the pairs move nearly identically in the same direction. “Nearly identically” is an important distinction to make because correlation only looks at direction but not magnitude. For example, one pair may move up 100 pips (percentages in point) while another moves down 70 pips. Both pairs may have a very high inverse correlation, even though the size of the movement is different.
If a reading is below -70 and above 70, it is considered to have strong correlation, as the movements of one are largely reflected in movements of the other. Readings anywhere between -70 and 70, on the other hand, mean that the pairs are less correlated. With forex correlation coefficients near the zero mark, both pairs are showing little or no detectable relationship with one another.
