How to trade on forex pair correlations
You can trade on forex pair correlations by identifying which currency pairs have a positive or negative correlation to each other. In the conventional sense, you would open two of the same positions if the correlation was positive, or two opposing positions if the correlation was negative.
This is because if there was a perfect negative correlation between USD/CAD and AUD/USD, having a long position on both pairs would effectively cancel each other out since the pairs would be assumed to move in opposing directions. But, if the correlation was perfectly positive, separate long positions on different pairs might help to increase your profits – or it could increase your losses if your forecasts are incorrect.
Traders will typically take positions on correlated pairs in order to diversify themselves while maintaining the same overall direction – either up or down. This could be to protect themselves from the risk of a single pair moving against them, as they will still have the opportunity to profit on the other pair if that happens. It should be stated, that perfectly correlated currency pairs are very rare, and there is always a degree of uncertainty when trading the financial markets.
You can also trade on forex pair correlations to hedge your risk on your active currency trades. For example, you could take out a long position on USD/CHF to hedge any losses you might incur on an active long EUR/USD position. That’s because these two currency pairs have a strong historical negative correlation.
Let’s say you’ve put £10 per point of movement on EUR/USD. To hedge your exposure, you put £8.50 per point of movement on USD/CHF and both currency pairs move 10 points. EUR/USD falls 10 points, resulting in a -£100 loss but, given the negative correlation, USD/CHF rises 10 points for an £85 gain.
While there is still a net loss of -£15, the £85 profit from the USD/CHF position meant that the loss was not -£100, as if you had only opened the EUR/USD trade. Alternatively, you could open two opposite positions on two positively correlated pairs, and the gains on one would offset the losses on the other.
An example of a positively correlated hedge would be if you thought that EUR/USD and GBP/USD were about to break their positive correlation. This could be because the Bank of England is expected to dramatically alter interest rates, or there is economic slowdown expected in the eurozone. If this was the case, you might choose to take a temporary short position on GBP/USD to offset any losses on your long EUR/USD position.
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EUR/USD and GBP/USD correlation trade example
EUR/USD and GBP/USD are positively correlated forex pairs, with an increase or decrease in one often seeing an equal increase of decrease in the other. The reason for this correlation is the close relationship between the US dollar, the euro and the pound – with these three currencies being entwined by the strong economic ties between each of their respective economies.
As an example of the positive correlation between these two pairs, you could open two long positions on the EUR/USD and the GBP/USD currency pairs. If the correlation is currently present in the market and if the pairs increased in price, you could potentially increase your profit.
Equally, you could open two short positions on these pairs if you believed that the price of one was about to fall. If the positive correlation was currently strong, you would expect the price of the other to fall alongside it.
