Currencies and currency pairs such as the euro dollar, correlate against a variety of commodities, markets and economic indicators, and for the trader or investor, it is vital that you understand these relationships for two reasons. Firstly as an investor in other assets, whether these are commodities such as gold or oil, or market assets such as stocks, bonds and commodities, the strength or weakness of a currency can dictate the likely performance of the assets. Secondly, if two assets or currencies correlate, they offer ideal opportunities for hedging risk.

For those of you new to the concept of correlation, this is simply the relationship that two data sets have to one another. If we take a simple example, consider the relation between ice cream sales and the weather. As the days get warmer, ice cream sales will increase, and conversely as the days get colder, then ice cream sales fall. In other words the two correlate directly with one another, so as one increases, so does the other, and as one falls the other also falls. Now in this case both data sets correlate directly, but there is also another relationship, whereby two sets of data correlate inversely, or in other words as one goes up, the other goes down and visa versa. An example of this might be the cost of a non essential item such as a newspaper – increase the price and demand falls, reduce the price and demand rises. This is an inverse correlation. All correlation is measured on a scale between 0 and 1 for direct correlation, and 0 to -1, for inverse correlation, with 1(or -1) being perfect correlation, which rarely happens in the real world. For a meaningful analysis, anything less than 0.7 is considered by most forex analysts to be meaningless, at least for us as currency traders.  It is also important to realize that these relationships are constantly changing, and will also change depending on which particular timescale you are considering, so that even though the euro dollar currency pair may be correlating with the pound dollar pair on a daily basis at 0.85, this relationship may be very different on the week, or month. So these relationships can only ever be a guide to our trading, as they shift constantly, and rarely hold steady for long periods. So how do they help us in our currency trading?

Firstly ofcourse at a very simple level we do not want to enter a trade which moves in one direction, only to subsequently open another trade which then cancels out the first, or alternatively have two trades which move in the same direction, both of which are easily done! Now in some cases you may want to open a position which is hedged, where one trade offsets another, or alternatively a situation where you are adding to a market direction position but using another currency pair, rather thean the original one. These strategies are fine, but you do need to understand which pairs correlate with the euro vs dollar, and the most common ones are as follows :

  • USD/CHF – this is a classic correlation and one which tends to remain relatively constant provided you take a long term view. This is generally around -90 for the pair, so any move down in the euro vs dollar, will result in an upward move in the dollar swiss.
  • EUR/GBP – again this is a positive correlation with the two pairs moving with one another. On a daily basis this will generally be much the same as for the USD/CHF and in the high 80’s or low 90’s and currently averages + 89
  • GBP/CHF – this is an inverse relationship and is generally around the high 70’s to low 80’s – currently around -78
  • GBP/USD – this used to be a very reliable relationship, but in the last 12 months, has fallen out completely. Just as an example the two pairs were generally correlated at +90 or even higher – this is no longer the case which only proves the point that whilst these relationship are useful, you cannot consider them as a guarantee.

One of the trades I use myself is a hedge position, using two contracts in one direction, and hedged with a correlating trade in the opposite direction. Now many people ask the question, why trade with 3 contracts, when effectively one contract would achieve the same objective. In other words, in a perfect world, two of the contrcts would cancel one another out, leaving one position open. The answer is, that we do not live in a perfect world, and currencies rarely ( if ever ) correlate perfectly ( ie 1.0), so there is always a divergence in the positions. The reason for the hedge is precisely that – to hedge risk. If I am correct in the direction, then my profit is reduced, but if I am wrong, then my loss is reduced also, and the trade avoids the use of stop losses, which can and do become the target for unscrupulous brokers. Using this strategy, we can avoid using a stop loss, but reduce our risk on the trade using the hedged pair. A simple strategy but one to be used when you are not certain about the direction, or simply prefer not to use a stop loss. You can ofcourse weight the hedge in one direction or the other, by holding more contracts in the direction you favour.

So in summary, understading correlation is an important part of currency trading, and even if you never use it as a strategy, it is important you understand that it exists.