Forex Correlation Pairs - What Is Currency Correlation in Trading?

Knowing how currencies correlate can benefit your forex trading performance. Imagine forex pairs performing on a stage around the world. While some move in perfect unison, others have completely different rhythms. The idea of currency correlation helps traders manage risk and develop complex trading plans. Becoming proficient in correlation trading could open up new profitable prospects in the forex market, regardless of your level of experience.

Table of Contents

Key Takeaways

• Fundamentals of Currency Correlation: With a range of +1 to -1, currency correlation in forex illustrates the mathematical relationship between currency pairs and helps traders in understanding how various pairs move in respect to one another.
• Leverage correlation for risk management: Comprehending currency correlations is essential for risk management and portfolio diversification; trading several highly correlated pairs in the same direction efficiently increases risk exposure, while hedging measures can be employed with negatively correlated pairings.
• Dynamic Market Relationships: As currency correlations change over time in response to monetary policies, global events, and economic conditions, traders must constantly assess and modify their methods in order to maximize trading opportunities and maintain good risk management.
• Common Correlation Patterns: Important correlations to keep an eye on include EUR/USD and USD/CHF, EUR/USD and GBP/USD, and commodity-currency correlations between gold and oil prices, such as AUD/USD and USD/CAD.

What is correlation in forex trading?

In forex trading, correlation refers to the statistical relationship between different currency pairs - specifically how they move in relation to each other.

Typically, correlation is expressed as a percentage. Two markets will always move in the same way if they are 100% correlated. Both will rise when the first does. We refer to this as a perfect correlation.

Conversely, a 50% correlation indicates that although the two markets may not always move in unison, they typically move in the same direction.

Since trading correlated pairs can either reduce exposure (negatively correlated) or increase risk (positively correlated), an understanding of correlations helps traders in diversifying their portfolios or hedging holdings.

Types of correlations

Correlation is measured on a scale from -1 to +1:

• The tendency of two currency pairs to move in the same direction is known as positive correlation (+1).
• Two currency pairs that normally move in opposite directions are known as negative correlation (-1).
• When two currency pairs' movements do not consistently correlate, the result is zero correlation.

Example of currency correlation

The correlation between the EUR/USD and USD/CHF currency pairs during the 2008 global financial crisis is an excellent illustration of currency correlation in history.

The USD/CHF and EUR/USD currency pairs have a significant negative correlation during periods of high market volatility. During the global financial crisis, investors rushed to the U.S. dollar as a safe haven asset, which resulted in the USD appreciating against the euro and Swiss franc.

• EUR/USD: As fear grew, the dollar got stronger and the euro fell.
• USD/CHF: The Swiss franc also strengthened, but not as quickly as the USD. This caused USD/CHF to move in the opposite direction of EUR/USD, with USD/CHF rising.

The two pairs showed an inverse correlation during this historical period (see charts below), with a strengthening US dollar pushing EUR/USD lower and USD/CHF higher at the same time. During difficult financial conditions, this correlation allowed traders to diversify or hedge their positions.

Weekly EUR USD and USDCHF chart for the year 2008:

Forex correlation pairs

The following are the most common correlations between currency pairs:

• EUR/USD and USD/CHF show a strong negative correlation (around -0.95) because the Swiss Franc historically moves similarly to the Euro, and when both are paired against the USD, they move in opposite directions. As the Swiss National Bank often aligns its monetary policy with the ECB, this correlation remains fairly stable.
• EUR/USD and GBP/USD display a strong positive correlation (approximately +0.95) as both the Eurozone and UK economies are closely linked through trade and tend to be affected by similar economic factors. Additionally, both currencies often move similarly against the US dollar due to their status as major European currencies.
• AUD/USD and NZD/USD exhibit a very strong positive correlation (about +0.95) because both Australia and New Zealand have commodity-based economies, similar trading partners (especially China), and their economic cycles often align. Both currencies are also considered "risk currencies" that respond similarly to global risk sentiment.
• USD/CAD and AUD/USD show a negative correlation (around -0.85) since the Canadian Dollar is heavily influenced by oil prices while the Australian Dollar is more affected by metal and mineral prices. However, both are commodity currencies, which explains the strong relationship.
• EUR/JPY and GBP/JPY demonstrate a strong positive correlation (approximately +0.90) because both pairs are heavily influenced by risk sentiment in the market. When investors seek safe-haven assets, both pairs tend to decline as money flows into the Japanese Yen.
• USD/CHF and GBP/CHF maintain a strong positive correlation (around +0.90) as both pairs involve the Swiss Franc, which often moves uniformly against other major currencies due to Switzerland's role as a financial safe haven and its monetary policy alignment with the Eurozone.

These correlations can change over time depending on market conditions, so traders should monitor them regularly.

Correlation between EUR/USD and other currency pairs

Let’s examine the table illustrating the correlation of EUR/USD with other popular currency pairs:

Commodity correlations

Commodities prices also correlate with currency pairs. The following table illustrates how different commodity assets move in a similar way or in opposition to the price movements of a currency pair.

1. USD and gold

The US Dollar and gold typically maintain a strong negative correlation, meaning they often move in opposite directions. This inverse relationship exists because gold is priced in US dollars globally, so when the dollar weakens, gold becomes cheaper for holders of other currencies, increasing demand and driving up gold prices. Conversely, when the USD strengthens, gold becomes more expensive for international buyers, potentially reducing demand and lowering gold prices.

This correlation becomes particularly evident during periods of economic uncertainty or market stress. For instance, during the 2008 financial crisis, as the Federal Reserve implemented quantitative easing and lowered interest rates, the USD weakened while gold prices surged from around $800 to over $1,900 per ounce by 2011. However, it's important to note that this correlation isn't perfect and can break down during certain market conditions, such as when both gold and the USD act as safe-haven assets during global market turmoil, causing both to rise simultaneously despite their typically inverse relationship.

1. AUD/USD and copper

The AUD/USD and copper prices typically display a strong positive correlation due to Australia's significant role in global copper exports and mining. As one of the world's largest copper producers, Australia's economic health is closely tied to copper prices, which directly influences the value of its currency. When copper prices rise, it generally indicates strong industrial demand and global economic growth, which tends to boost the Australian dollar against the USD.

This correlation is particularly evident during major economic shifts or commodity super-cycles. For example, during the 2020-2021 commodity boom, as copper prices surged from around $2.10 to over $4.50 per pound, the AUD/USD pair rose from 0.5500 to 0.8000, demonstrating their strong positive relationship. However, traders should note that this correlation can temporarily weaken during periods of significant market stress or when other factors, such as interest rate differentials or broader risk sentiment, take precedence in driving currency movements.

1. USD/NOK and Brent crude

The USD/NOK (US Dollar/Norwegian Krone) pair and Brent crude oil prices typically display a strong negative correlation due to Norway's position as Western Europe's largest oil producer and exporter. As oil is Norway's primary export commodity, higher oil prices generally strengthen the Norwegian Krone, causing USD/NOK to fall. This relationship is particularly evident when oil prices experience significant movements - when Brent crude prices rise, Norway's export revenues increase, improving its trade balance and strengthening the NOK against the USD.

A clear example of this correlation was seen during the oil price crash in early 2020, when Brent crude plummeted from around $60 to $20 per barrel due to the COVID-19 pandemic. During this period, USD/NOK surged from approximately 9.00 to over 12.00, reflecting the severe weakening of the Norwegian Krone as oil revenues declined dramatically. However, like most currency correlations, the relationship between USD/NOK and oil prices can vary in strength depending on other factors such as global risk sentiment, interest rate differentials, and broader economic conditions affecting either country.

How to trade forex correlation pairs

The foundation of successful correlation trading lies in identifying strongly correlated pairs through historical data analysis. Traders often focus on well-established relationships like AUD/USD and NZD/USD for positive correlations, or EUR/USD and USD/CHF for negative correlations. This identification process relies on correlation coefficients, which range from +1 to -1, indicating the strength and direction of relationships.

Smart traders use correlations for two primary purposes: diversification and hedging. Diversification involves avoiding overexposure to similarly moving pairs, while hedging uses negative correlations to offset potential losses. For instance, a trader might balance a long EUR/USD position with a short USD/CHF position to manage risk exposure.

Strategy development in correlation trading often centers around confirmation and inverse trading approaches. Both strategies require careful attention to economic indicators and news events that could impact correlated pairs.

Confirmation strategy

The confirmation strategy uses multiple correlated pairs to validate trading signals, particularly works well with EUR/USD and GBP/USD due to their strong positive correlation. When implementing this, first identify a potential trade setup in EUR/USD using your preferred technical analysis method, such as a break of a key resistance level. Then, check if GBP/USD shows a similar setup. If both pairs demonstrate the same technical pattern, this double confirmation increases the trade's reliability.

For instance, if EUR/USD breaks above 1.0800 with strong momentum, and simultaneously GBP/USD breaks above 1.2700, this dual confirmation suggests a stronger USD weakness trend. However, position sizing becomes crucial here - instead of risking 1% on each pair, consider risking 0.5% on each to maintain appropriate total exposure.

Inverse strategy

Inverse trading capitalizes on negative correlations for balanced market exposure, it works well with EUR/USD and USD/CHF due to their typically negative correlation. When EUR/USD forms a bullish pattern, look for a corresponding bearish setup in USD/CHF. For example, if EUR/USD bounces off a strong support level at 1.0750, you might enter a long position while simultaneously looking for a short entry in USD/CHF near a resistance level.

Regular monitoring and adaptation are crucial as correlation relationships evolve. Successful traders consistently review correlation matrices and adjust their strategies based on changing market conditions. This dynamic approach, combined with strict risk management through appropriate stop-loss placement and position sizing, helps protect against the amplified risks inherent in correlation trading.

Conclusion

Understanding and effectively trading currency correlations can significantly enhance your forex trading strategy, but it requires careful practice and consistent monitoring of market relationships. Before risking real capital, it's highly recommended to test correlation trading strategies using a forex trading demo account. This allows you to observe how different currency pairs interact, practice proper position sizing, and develop a feel for managing multiple correlated positions without financial risk.

Remember that correlation trading is not just about identifying related currency movements – it's about developing a comprehensive trading approach that incorporates proper risk management, technical analysis, and market awareness. Whether you're using correlations for confirmation, hedging, or diversification, success comes from understanding that these relationships are dynamic and require regular adjustment of your trading strategy. By starting with a demo account and gradually building your experience with correlated pairs, you can develop the skills needed to potentially capitalize on these complex market relationships while managing risk effectively.

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