Sometimes the charts of different currency pairs echo each other’s movements, and sometimes they seem to move as opposites. This phenomenon is known as positive or negative correlation within the forex trading market, and it can be a powerful tool for savvy traders.
There are all sorts of reasons for correlation, for example, different monetary policies, changes in commodity prices, and various economic and political situations.
With the fluidity of global economics, such as diverging monetary policies between nations and the ups and downs of the commodities markets, correlation between sets of currency pairs does change over time. However, certain trends tend to remain static. For example, NZD/USD and AUD/USD tend toward fairly strong positive correlation despite the significant differences in the economic situations of Australia and New Zealand.
On the other hand, EUR/USD and USD/CHF generally have a fairly strong negative correlation, with the lower liquidity of the Swissie giving it greater volatility. Therefore, when the USD/CHF is bullish, traders historically expect the EUR/USD to become bearish, and vice versa.
Statistical techniques have been established to measure degrees of correlation. The most commonly used system illustrates that degree with a coefficient between +1 and –1, where +1 indicates two currency pairs that move in perfect synchronisation, –1 indicates two currency pairs that move as mirror images, and 0 indicates there is no correlation between the two pairs and they move at random.
There are many sets of correlation tables for the most actively traded currency pairs available online, so there’s no need for each trader to calculate their own set to trade the majors. However, for less actively traded currency pairs, calculating correlations can be accomplished with a spreadsheet program such as Excel and by downloading historical price tables from one’s online forex trading platform.
Correlation is calculated over different periods of time, with the most common intervals being one month, three months, six months, and one year. Comparing degrees of correlation over time emphasizes the overall volatility of the forex trading market and helps traders to plan their portfolio, particularly as regards exposure.
Correlation is important for all traders. Technical analysts know that, when the chart of one currency pair shows a certain promising pattern, strongly correlated pairs are also worth examining. As a hypothetical example, if EUR/USD signals a break above a trendline, one should examine GBP/USD for a similar pattern, and USD/CHF for its reverse.
The fundamental analyst can use correlation in several ways. First, knowing currency pair correlations helps one avoid contradictory positions, e.g., going long on both the EUR/USD and USD/CHF makes no sense as with their strong negative correlation, the loss suffered from one trade would cancel out the profit earned from the other.
Another fundamental use for correlation is to diversify one’s portfolio by using currency pairs with strong but not absolute correlation to strengthen one’s position within the market. An example would be going long on both the EUR/USD and GBP/USD. With a positive correlation of 0.71 over the twelve months preceding November 2007, holding such a position spreads the trader’s risk while still remaining USD bearish overall.
source : http://forextradings.com.au
