Currency Trading Online

Currency Correlation: Now that we've looked at some of the major currencies and all the economic factors that can affect them from a fundamental perspective,  let's look at how the currency pairs themselves correlate with one another. Why? - quite simply, if you do not appreciate which currency pair correlates with another, then you could be entering trades which offset one another as a hedge. This is fine if it was planned as part of the trade, but not so good if you only realise after opening the trades!

Currency Trading Online : Correlation

For those of you who have no idea of what correlation means, the following is a short explanation. In essence correlation is a statistical term which illustrates in mathematical terms the inter relationship between two or more quantitative or qualitative variable terms. There are various types of correlation but for currency trading we only need to consider Pearson's product moment coefficient ρ x,y. When ρ x,y is +1 or -1, then we have what is termed perfect correlation ( this rarely occurs ). If ρ is +1 then the two variables correlate directly, and if -1 then they correlate inversely.  The further the figure is from +1 or -1 then the less the two variables correlate. Let's take a couple of simple examples which I hope will explain the concept in simple terms.

As an example of almost perfect correlation consider the length of someone's foot and their shoe size. As measurements increase in foot size, then shoe size will also increase, and as the foot size reduces, so does the shoe size and we end up with the chart on the left.  As we can see, as the shoe size increases then so does the foot size as we move up the red line, and in reverse foot size reduces as does shoe size. So we can say that these two variables correlate directly  100% of the time, so a tiny increase in one, will result in a tiny increase in the other. Let's look at inverse correlation.

A good example for inverse correlation would be your car's fuel efficiency and how much you have to pay for fuel per mile. The less efficient your engine, the more you have to pay per mile. If you drive a Bentley which only delivers 12 miles per gallon, then your cost per mile will be considerably more than if you drive a Fiat at 40 miles per gallon. So engine efficiency and cost per mile are inversely correlated almost perfectly, but this time the coefficient is -1. In this case, as the engine efficiency goes down, so your cost per mile goes up, and vica versa. They are still perfectly correlated but this time the coefficient is negative, telling us that as one goes in one direction, then the other variable moves in the opposite direction. Is this important to us as currency and forex traders - YES!!

Now the above table is not a complete list but these are some of the major pairs that correlate either directly or inversely - there are many others. When looking at correlation, there are several things you need to consider - these are as follows :

1. Any figure less than 0.7 ( -ve or +ve ) has little meaning
2. 0.7 to 0.9 means there is strong to high correlation
3. 0.9 to 1.0 means there is very strong correlation
4. The longer the time period then the more valid the correlation figure

So if we take the EUR/USD and GBP/USD as an example, we can see that over the longer periods of 1 and 2 years, there is a strong to high direct correlation between the pairs. So if you have a long GBP/USD position and a long EUR/USD position, then they will both move in the same direction over the long term. Now on a daily move this correlation may change, and will do so throughout the day, but in the longer term, this relationship will prevail.

So what happens with the EUR/USD and the USD/CHF - the exact opposite. As the EUR/USD currency pair go up, so the USD/CHF pair will go down. So if you had one long position in each currency pair ( of an equal number of contracts) then the trades would tend to cancel each another out. Once we are aware that pairs correlate, can we use this to our advantage in currency trading - the answer of course is yes. Here's how:

Currency Trading Online : The Hedge Trade

This is a favourite trade of mine, when I'm not sure which direction the currency pair is heading, but I am reasonably confident I am right. Let's take the EUR/USD and USD/CHF as an example. I think the EUR/USD is going to rise in price so I want to go long, but I'm not 100% sure I'm right so I'm going to hedge the trade with the USD/CHF. Now if I buy the same number of contracts then clearly it's not going to move very much, so instead I will buy 2 EUR/USD and also buy 1 USD/CHF, so the trade has a bias in the direction I think the EUR/USD is going. If I am right, then my two contracts on the EUR/USD are positive, and the one contract on the USD/CHF is negative so if the pair moved 100 pips, then I would have a profit of around 100 pips ( rather than 200). If the reverse happens then I would only have a loss of 100 pips ( rather than 200 ). How and when you close this trade set up is up to you, but you must close the trade as a basket - do not try to take the profitable trades and leave the negative trades open - it defeats the object of the hedge!!

Now there is a lot more to correlation, and how to use it - but for now, just make sure you understand which currency pairs correlate so that you do not open off setting trades by mistake. The next topic I would like to look at is the important issue of timescales for currency trading.

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