The foreign exchange market is a fast-paced, high-stakes arena where currencies from all over the world are bought and sold. To have any measure of success in this market, an investor must understand the factors that affect currency prices. Two such factors are correlation and volatility, which can be explained by understanding what currency pairs correlation means.
Correlation is a statistical term that measures how two sets of data relate to each other. The forex market represents how a pair of currencies trade against each other – for example, if the USD HKD option rallies, does USD/JPY also rally? A positive number indicates that as one currency increases in value, the other does as well. A negative number means that the other decreases when one currency increases in value.
Many forex brokers offer access to more than one hundred currency pairs. If there is a correlation between them, you need 100 different correlation calculations (one for each pair). Fortunately, the math behind correlation calculation allows you to calculate the overall correlation on just one currency pair with this simple formula:
Correlation = Covariance(X, Y) / [Standard Deviation(X) * Standard Deviation(Y)]
Simply put, covariance gives you an idea of how two assets move together, while standard deviation measures how far out of line the price movements are from the average. A positive number means that both assets are moving in the same direction, while a negative number means moving in opposite directions.
Traders use the volatility of a pair to set up their trades. Specifically, they are concerned with how volatile the pair is relative to its average volatility. When you calculate correlation for these pairs, if it comes out positive, it means that this pair tends to be more volatile than usual when another asset becomes more volatile. So when traders see an increase in correlation, they can expect increased volatility in the affected currency pair(s).
Correlation does not predict how high or low a pair will move but instead measures whether there is any relationship between two assets movements at all. If the value is above 0.3, there may be some relationship, but it’s weak. A value between 0.5 and 1 indicates a strong relationship, while anything over 1 indicates that the two moves are completely positively correlated.
In Asia, factoring currency pairs correlation into your trading can be helpful when you want to benefit from a breakout or avoid potential risk during periods of consolidation. A low correlation between pairs means they typically do not move in unison, so there may be high volatility without a high chance of emerging trends. This is an excellent way to get into trades on short notice because it enables you to take time away from the market without having to worry about missing out on profits.
On the other hand, traders who plan their entries and exits based on currency pairs correlation see trading opportunities where others don’t because they know which way price will break out instead of trading blind.
One instance where this may be true is when high correlation values show up sporadically and don’t last long because other market forces cause these assets to revert to how they typically act.
Another risk is that everything will act as expected but unexpectedly; if your trading strategy relies on two assets trading together, it won’t work because the movements are reversed. If one asset moves higher while another moves lower (reversely correlated), then your position will lose money even though both assets moved in the direction you expected.
The last risk is that correlation will show a strong relationship, but you lose money because the price does not follow through. For example, if your trading strategy uses a breakout as an entry trigger and there’s a high positive correlation between two assets, it may also signal weakness in the trade.
If you are new to FX trading it is always advisable to start your trading journey with paper trading. This term refers to using a demo trading account to test various strategies and analysis methods before making a real money deposit into your trading account and investing your funds.
Financial trading is fun, as long as you understand the risks associated with each instrument and never trade with money you can’t afford to lose. It is also imperative that you partner with a reputable brokerage that has a long track-record of legitimate trading practices. There will undoubtably be many fly-by-night scammers contacting you with promises of quick profit. Always remember that if it sounds too good to be true, it almost certainly is. Trading requires calm and calculated decision-making. At all times.