Currency pairs correlation is usually the thing that all have heard about before but nobody really knows how to use it properly.
We’re going to tell you about a simple and sound strategy of practical application of the correlation that does work. First, let’s deal with terminology.
Understanding Currency Pairs Correlation
We’ll not go into the details of correlation calculation theory – you can find the information online if you wish.
Simply put, correlation in the Forex market is the measure of how synchronously currency pairs move. At that, the higher is the value of correlation, the longer the pairs move in unison.
There is an inverse correlation where pairs move in unison but in the opposite directions, for example, EUR/USD and USD/CHF.
Forex correlation occurs due to a small number of currencies that can make up a currency pair. Taking EUR/JPY and AUD/JPY as an example, we can see the Japanese yen included in both pairs and being the source of correlation. Therefore, if yen begins to strengthen, these two pairs will move in the same direction.
However, US dollar itself is even a greater source of correlation. Almost all pairs are dependent on it; if it starts to gain, other pairs (even those not including USD) will be directly or inversely correlated with it.
Currency pairs are correlated with:
- Each other due to a common currency that makes them up.
- Correlation of currencies and indexes, for example, the Dollar Index or the S&P 500 Index.
- Commodity assets. Correlation of the Canadian dollar with oil and the Australian dollar with gold is widely known.
Logically arguing, this correlation does nothing but make trades worse since it severely limits the number of financial instruments used for trading.
For example, you wouldn’t sell EUR/USD and buy GBP/USD at the same time.
Currency Pairs Correlation Strategy
The strategy is easy to understand but not everyone can apply it in practice for it requires strong discipline and assiduity.
What do we need? Almost nothing except realizing that there is a correlation between currency pairs. We’re also not going to use correlation tables because it is obvious that AUD/USD, EUR/USD and GBP/USD correlate with each other.
The key to the strategy is as follows: we must use currency pairs’ correlation as a source of cross currency signals. For example, if you have got a signal for EUR/USD, you should make a further analysis of GBP/USD (and other pairs) to check for any confirmation signals. If GBP/USD signals in the same direction, you can buy EUR/USD with greater confidence.
This strategy manifests itself even better as a signals filter: for example, you shouldn’t buy the euro, no matter how strong signal you’ve got, if the pound has broken a major level and can only move downwards.
Example 1. Level
When you analyze the pair that you typically trade, you’ll not always be able to determine some level, but you might find something more interesting after analyzing other correlating financial instruments.
Let’s examine this situation in more details. The Dollar Index (DXY) has broken a major level and then pulled back to this level what they call «retest». It’s a usual case in technical analysis – as we know it, it signals a buying opportunity. Since the Dollar Index is inversely correlated with the pound, it’s a signal for us to sell the pound. As we can see, the pound responded accordingly.
Example 2. Other
You can look for signals based on the currency pairs correlation strategy not only on the chart but also in other sources.
This could be literally any signal for the financial instrument correlated with your pair. For example, while trading the euro, you should be careful during news releases for the pound since the volatility of GBP/USD directly affects EUR/USD.
You shouldn’t also sell the pound when 58% of traders are willing to sell the euro.
Let’s consider this example. Assuming that we trade GBP/USD and have got a Buy signal. When analyzing the ratio of traders’ positions, we can see some «uncertainty» about the pound. If we look at correlating pairs, the situation changes dramatically. All the correlating pairs signal buying, so the signal to buy the pound is confirmed.
Example 3. Pattern
In this case, any market pattern serves as a source of signal.
Here is a very good example. Have you ever seen a pattern of questionable quality? So, checking other pairs is a great chance to confirm the quality of the pattern you’ve identified; if the pattern is not reliable on all currency charts, it’s best not to trade it.
Let’s sum it up
When reading this article, the following question might arise: «Why not to trade the financial instrument that generates a clearer signal?».
- First, not all brokers enables trading indexes, oil, etc.
- Second, traders usually have their favorite financial instrument they got used to and feel uncomfortable trading with other instruments.
- Finally, the signal might be generated by several correlating pairs. If this occurs, which pair to choose?
This is why it’s best to trade the pair which is the most suitable for you and not to switch between financial instruments; as for correlation, it should be applied as a signal confirmation.