How do we read /use currency correlation in forex trading.

Currency correlation in forex is either negative, positive or random.

Negative currency correlation

When you see 2 currency pairs completely moving in opposite directions, they have a negative correlation relationship.

This happens when the base currency of the currency pair is the quote currency of the other pair.

This simply means,

When the value of the base currency strengthens, for instance USD/JPY. The currency will rise.

Conversely, if we consider, EUR/USD, where US.dollar is the quote, it means the currency pair will fall.

The negative correlation between EUR/USD and USD/JPY restricts traders from taking positions in the same direction.

Reason; When you win one trade, you are more likely to lose on another trade.

Moreover, you never sure whether the gains will cater for the loss made in the counter trade due to different volatility levels.

Let’s have a look at these charts EUR/USD,Weekly chart and USD/JPY,Weekly chart .

   

From the above charts, you can clearly see how the 2 pairs move opposite of each other.

 In addition, the negative correlation between these currency pairs also helps you to determine the amount of risk on the trades .

For example,

if you go short on a EUR/USD and long on the USD/JPY, it’s the same as holding two positions on the same pair. This is double risk.

This means both trades can go against your prediction at the same time.

Positive correlation

A clear example on double risk exposure is well explained using positively correlated pairs.

For example if you short both EUR/USD and GBP/USD; both are positively related pairs.

This signals a possible double risk from the same position since all will most likely move in same direction.

Charts showing the correlation between EUR/USD and GBP/USD

     

 Assume you risk 2% of your account on each trade and you take trade on each pair at the same time.

Remember these currency pairs move in the same direction almost all the time.

If your prediction goes wrong this implies you will lose 2% on the first position and the 2% for second position.

On both trades, it makes it 4% of your account at the same time.

That is what a double risk exposure entails!

How do you use currency correlation when trading forex

You can use negative and positive currency correlation in majorly 2 ways.

1.Determine Trend direction

For positive correlated pairs, when one of the pairs shows a strong movement and the other is just ranging, the later is likely to take the same direction after the range.

For example if the EUR/USD is trending down and GBP/USD is ranging.

 You should think twice before buying GBP/USD.  It has higher chances of going down due to a possible USD strength.

In the Forex market, currencies are traded in pairs. The first currency is the base and the second is the quote /counter currency.

When base currency is stronger, its price rises and moves in an upward direction in relation to its quote currency.

For example, when the economic news strengthens the USD.

 USD/JPY & USD/CHF will move up showing the strength of USD over the quote currencies.

However, EUR/USD and GBP/USD will fall taking the down trend due to the increase in value of their quote currencies.

2. Risk exposure

You can use currency correlation to determine the amount of risk your Forex trading account is exposed to.

For example,

If you buy/sell several currency pairs with a strong positive correlation, then you are exposed to higher directional risk.

Also if you buy and sell several currency pairs with a strong negative correlation, you expose your account to a double risk in case the trades go wrong. 

For example,

If you buy EUR/USD and sell USD/JPY. If EUR/USD goes against you, so does USD/JPY.

In addition, buying or selling both EUR/USD and USD/JPY will counteract the moves in each pair.

The two positions cancel each other out.

 

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