Currencies on Forex are traded in pairs, and each currency in pair depend on different circumstances. There is a relationship and mutual dependence of the currency units.
Risk control can be implemented only with the help of information about all currency correlations.
Imagine that a currency pair A moves similar to the currency pair B. The trader carefully follows the progress of this pair. If the growth of pair A is possible, the trader should open a buy order. However, the trader does not oversee the pair B. The technical and fundamental analysis shows that this pair will soon have its price reduced. If a trader wants to remain profitable, they'd have to sell the currency pair B. The result of trading will be the same if to open a buy order at the same time or to open long positions for both pairs which are moved in different directions.
Risk control can be implementedonly with the help of the information about all currency correlations and also all changes which take place over time.
The correlation coefficient can range from -1 to +1. If the correlation coefficient is equal to +1 this means that A and B currency pairs move in the same direction. A zero correlation means that the relationship of the currency pairs has irregular character.
Types of Currency Correlation
When the correlation coefficient is less than +1 this means that the currency pairs move in the same direction. If the value of the coefficient is close to +1 the currency pairs move in the same direction most of time.
If the negative value is more than -1 the currency pairs move in the opposite directions but not constantly. And the coefficient value which is close to -1 means that they move in the opposite directions most of the time.
How to Use Currency Correlation in Forex Trading
Correlation is a fast and constantly changing phenomenon. Just take a look at the level of the correlation coefficient for the last two days and the correlation for a significant period, for example, for a month or a year. When there is an evident difference between the short-term and a long-term values trader should open an order. But how can it be done? For example, the correlation coefficient of A and B pairs for the previous year is 0.98. It means that these pairs were moving in the same direction almost all the time. When the price of pair A grows the price of pair B also increases with the same speed. But suddenly you find out that the correlation coefficient for the last week or month is equal to 0.10 which means that the pairs had the same direction but different speed.
What should be done in such a situation? A trader can determine which currency pair moves more slowly and accordingly determine when to open an order.
Let's say that A and B pairs are moving in the same direction with the correlation coefficient more than 0.60. But at the same time, the trader sees that the correlation coefficient was equal to 0.20 for the last days. So the trader understands which pair has influenced the reduction of the correlation level and can open a buy order. In addition to that, the trader can no longer follow this currency pair.