What You Need to Know About Currency Correlation as a Forex Trader
Currency correlation among currency pairs can seriously impact any forex trader's trading activities. The trader who is unaware of such correlations might end up lowering his profit potential or even end up taking on more risk.
What Is Currency Correlation?
In financial terms, correlation represents the relationship between two instruments. In the world of forex, this would be the relationship between two pairs of currencies.
The relationship can be either positive or inverse. Two pairs of currencies that have a positive correlation will tend to move synchronously. Two currency pairs that have a negative correlation will tend to move in opposing directions.
A measure of correlation is called the "correlation coefficient". Its value can range between -1 and +1. -1 signifies 100% negative correlation, while +1 signifies 100% positive correlation.
A "0" correlation coefficient means that there is no correlation between the two pairs of currencies. They will move randomly from one another.
An Example of Positive Currency Correlation
Two pairs of currencies that tend to have a positive correlation are EUR/USD and GBP/USD. Their price charts are almost identical, especially if you compare them on longer term time frames.
This represents a very positive correlation between the two pairs of currencies over the long term. It may not be evident over a short period of a few days; however, on a longer time frame, the positive correlation becomes obvious.
The correlation exists because the British Pound (GBP) and the Euro (EUR) are both European currencies with similar fundamental risks. As a result, their exchange rates with the U.S. Dollar (USD) will tend to move in similar directions.
Some Quick Points On Currency Correlation
As I mentioned earlier, the correlation between two pairs of currencies can be measured between a value of -1 and +1. -1 means that the two pairs move opposite from one another 100% of the time, while +1 means that they will move together in the same direction 100% of the time.
The following guidelines can help you when evaluating the correlation between two pairs of currencies:
* A correlation becomes more significant when looking at longer term time frames.
* Positive or negative 0.6 to 0.9 would signify a strong correlation, with the higher number indicating a high amount of correlation.
* A correlation coefficient with an absolute value between 0.9 and 1.0 would mean the highest correlation.
* A correlation coefficient with an absolute value less than 0.5 represents a weak correlation.
How Currency Correlation Can Affect Forex Trading
By being aware of the correlation among certain currency pairs, a forex trader can avoid taking positions which may result in additional risk.
In our previous example, a trader may essentially double his risk exposure if he were to open a position in EUR/USD and GBP/USD pairs at the same time. This is because both pairs are positively correlated.
On the other hand, taking positions in two negatively correlated currency pairs won't result in additional risk exposure. However, it would have the effect of sabotaging profit potential.
Being knowledgeable of correlations among currency pairs will be advantageous to any forex trader.
Article Source: FxTradingStock.com
About the Author
Learn more about currency correlation and how it can impact your forex trading. Stop by Rudolf Boquiren's site where you can learn how to build a forex trading system based on your trading style.
by: Rudolf Boquiren
Total views: 25
Word Count: 545
Date: Thu, 25 Nov 2010
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