Currency Correlations
The study of the correlation of different currency pairs is sometimes overlooked or misunderstood but it is a very important point that can cause many pitfalls if it is poorly absorbed.
The correlation coefficient is the level of connection that exists between two variables. This coefficient always varies between -1 and 1, also sometimes used the interval -100%, 100%. Variables with a correlation coefficient of 1 (100%) will evolve in the same direction and with the same magnitude. Variables with a correlation coefficient of -1 (= 100%) will evolve in the opposite direction and with the same magnitude. Variables with a correlation coefficient of 0 (= 0%) will be completely uncorrelated and evolve completely differently. Usually from a correlation of + / – 0.5 is considered that two assets are correlated and they are highly correlated from + / - 0.75.
The most important aspect of the study of correlations is the relationship with risk management. The study of risk management of a portfolio necessarily evokes portfolio diversification. Indeed, a properly diversified portfolio helps to limit the volatility of the portfolio thus limit the risks. But the quality of this diversification is inversely proportional to the absolute value of correlation coefficient.
For example, two assets in the portfolio with a “correlation” coefficient of 0.95 will be so connected at the level of risk, it would be almost twice the same position. Often, the two positions will be winners or both will lose, so it is not an effective diversification.
The first table shows the various cross-correlations at a given time and the second shows the evolution over time of these correlations. Indeed, the correlations are not static, they can increase or decrease and it will be interesting to monitor over time.
This data shows that taking a long position in the EUR / USD and simultaneously a long position in AUD / USD, GBP / USD and NZD / USD has almost doubled back position which creates a significant risk. It is not forbidden to do so but we must adapt the size of positions accordingly. If we take general position for 2% of capital, it will take a stand here, for example up to 1% on the EUR / USD and up to 1% on GBP / USD or choose one of the two pairs. The overall risk of the portfolio will remain within the limit of 2% which would not be the case if two positions of 2% each were combined.
For USD / CHF and USD / CAD, being inversely correlated to the EUR / USD, it will be careful to accumulation of a short position in USD / CHF and USD / CAD and a long position in EUR / USD. Conversely, wearing a position on the EUR / USD and simultaneously a position on the USD / JPY does not increase greatly the level of risk, both pairs being quite strongly uncorrelated.
Another aspect of the more advanced correlations is their use to work more pairs. For a beginner, it is better to focus on a single pair to understand the functioning of the market but then, trading will be done on two or more pairs. Correlated pairs with enough (or sufficiently inversely correlated), it will be possible to choose the pair that has the best relative strength.
For example, if the exchange rate EUR / USD, GBP / USD and AUD / USD are selected and a long signal appears simultaneously on all three pairs, which is likely, it will be interesting to choose among these three pairs, the one that will have the best force upward. Conversely a signal to short the pair with the largest downward trend will be chosen. This will maximize profits generally. This practice is not natural instinct which tells the pair the most (so in fact the least appropriate) will usually be chosen because they appear to have more potential but often it will be the one that evolves more slowly and will therefore the least profits.
However, this practice should be avoided at first, it is better to focus on a single pair, especially in day trading, because it requires simultaneously monitor several pairs which requires adequate computer equipment and some practice.
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