The high levels of volatility and leverage in the forex and CFD markets can be rewarding but are also well-known for being risky. While lucrative opportunities attract millions of traders across the globe, the reality is that the vast majority of retail traders lose money due to a lack of risk management strategies.
Therefore, it all comes down to a fundamental question: If a single currency pair exposes you to concentrated risk, how do you reduce that incurred risk while still retaining the possibility for profits?
The answer is currency pair correlations, a complex concept that is easy to use and can show you the "web of relationships" between different currency pairs. You can think of correlations as invisible connections in the forex environment between different currencies that create patterns that risk-savvy traders can use to their advantage to reduce risk.
For example, during the 2008 financial crisis, professional traders who understood the relationships between the major currency pairs took losses that were substantially smaller than the loss of value on portfolios that lacked any understanding of those relationships.
This thorough reference will walk you through both professional-grade techniques and everyday situations. From novice to expert trader, you will learn how to use currency correlations to manage forex risk. We will examine calculation procedures, real-world hedging strategies, and the broader issues involving cross-asset correlations through the lens of constructing robust trading portfolios.
What is Currency Pair Correlation?
Currency pair correlation is the statistical relationship between the price movement of two individual currency pairs. Simply stated, it is a measure of how closely or loosely two currency pairs move as compared to each other during a time period. This relationship is expressed with a correlation coefficient that ranges from +1 to -1, and affords traders a numerical measure of how correlated two assets are.
The two main forms of correlation are positive and negative correlation. Positive correlation occurs when two currency pairs tend to move together in the same direction. For example, EUR/USD and GBP/USD exhibit a strong positive correlation because both the Euro and British Pound are affected by similar economic factors and both pairs will have the US Dollar as their quote currency. This means that when the USD weakens both EUR/USD and GBP/USD will probably rise together.
Why Correlation is Important in Risk Management
By understanding correlation, risk management can be effective because it can expose hidden risk in what appears to be a diversified portfolio. Traders frequently make the error of believing that they are diversifying risk when in fact they are becoming more exposed to the same underlying factors.
For example, consider a trader who buys long in both EUR/USD and GBP/USD. This trader assumes they are diversifying risk. However, the correlation coefficient between these pairs is often +0.7 or above, meaning they trade in the same direction 70% of the time. The trader has in fact doubled their exposure to US Dollar weakness and European economy strength. If out of a sudden change in Federal Reserve policy, the Dollar gets stronger, these two positions will move against the trader at the same time, causing a double loss.
Interest rate differentials and the policies of central banks can also inform correlation structures. When the Federal Reserve is raising rates relative to other central banks, or while other central banks are still dovish, currency pairs that are US Dollar based tend to act in the same manner. In effect, the raising rates from the 2015-2018 Fed tightening cycle, created a strong response for many USD pairs, as the thought of dollar strength reinforced that market theme.
The correlation structure between currency pairs which are in a similar environment for monetary policy has the outlook to become correlated as central bank policies synchronize. For instance, during the European debt crisis, the safe-haven flows of the Swiss Franc and Japanese Yen strengthened their correlations as both offered shelter away from Euro denominated assets, solidifying the strong role of the War.
Conclusion: Currency correlations - The key to professional traders!
In the forex risk management toolbox, currency pair correlations represent one of the most powerful, yet least used (and understood) tools. Throughout this comprehensive guide, we have learned that deep understanding of currency relationships enables traders to identify a "structured" and professional approach to trading by bringing true risk management frameworks into the execution of trades that would otherwise be discretionary speculation.
Moving from understanding the basics of correlation -> acquiring the calculations for finding the correlation -> implementing the correlational risk/hedging strategies in the context of the market -> and continuing to monitor and adjust expectations for currency correlations to changing market conditions - is a clear learning path to take.
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