- Traders all around the world are looking for the best trades to make the most profit. Correlations are very important to a successful trader as traders can HEDGE positions or see if a correlated pair is about to BREAKOUT.
- Correlations are a statistical measure of how two currency pairs move in relation to each other.
- A measure of -1 is when they track perfectly opposite to each other for example if EURUSD went up 100 pips and AUDUSD went down 100pips they would have a correlation value of -1.
- On the other hand A value of 1 is when they both move perfectly with each other. So both move up 100 pips together. It is very rare to find perfect correlations but some are very close to 1. However a common example is A BONDS yield and price. So for example If the Price of the bond rises the yield falls and vice versa this is perfectly inversely correlated.
Here are some examples of Correlation over hourly charts on some of the most popular currency pairs.
AUDUSD - EURUSD : 0.949
AUDUSD - NZDUSD : 0.998
AUDUSD - GBPUSD : 0.957
EURUSD - NZDUSD : 0.954
EURUSD - GBPUSD : 0.999
NZDUSD - GBPUSD : 0.962
As you can see here some such as AUDUSD - NZDUSD are very highly correlated as is EURUSD and GBPUSD.
USES of CORRELATIONS:
- Firstly You can hedge open position with highly correlated pairs to "protect" yourself against moves for example if one goes up the other goes down and so should cancel each other out.
- However it is not as simple as that as There is a term normally used in stock trading called BETA COEFFICIENT, This is when something is benchmarked against an industry standard. For example;
I am looking to BUY stock XYZ, it has a beta value of 1.5 against the S&P500. You think that the S&P is going to rise 1% but instead of buying a futures contract in the S&P you buy the equivalent $ value of XYZ and due to its "HIGH BETA of 1.5" it should move 1.5% up with the market move tracking it closely but with more volatility.
So in this instance you make 1.5% as opposed to 1%. HOWEVER there are increased downside risks, if you were WRONG about the market direction and the S&P fell 1% you would be down 1.5%
So in the Currency markets Some pairs move more than others, for example while AUDUSD and NZDUSD are highly correlated AUDUSD might move 150 pips for NZDUSD 100 pips, and so to perfectly hedge you would need 1.5X the $ size of NZDUSD to counter out AUDUSD.
You can as opposed to hedging with two pairs just trade crosses.
- Let's say AUDUSD is 1 pip from breaking out of a trendline to the upside but on NZDUSD there is no such trendline (as they don't PERFECTLY correlate).
- Moments later AUDUSD is rising fast, now up 50pips. The NZDUSD will follow suit possibly only 30pips (better than nothing) but at a slight delay, only tiny but it's there, if you are quick enough you CAN CAPITALIZE on this but you must be quicker than the Algorithms that have been set up to fill a divergence between highly correlated pairs.
Correlation Across DIFFERENT world MARKETS:
- Many markets across the world are very highly correlated. for example here is the CAD
- and here is PALLADIUM:
As you can see very correlated and seemingly very different securites. Here is another example
And the S&P500 -
Hopefully throughout this you've learnt about the POWER of knowing about correlations. And as a trader YOU NEED to know what the professionals know.
Any question please feel free to ask.