Currency pair correlations attempt to explain the interaction of distinct values of forex pairs and their relationship with one another. This article reveals more about this subject.
Forex Currency Correlation
A forex currency correlation is a negative or positive relationship between two currency pairs. A positive correlation implies that the currency pairs move in the same direction, while a negative correlation suggests that the currency pairs move in opposites. Correlations provide you with the chance of realizing a considerable profit, and it is essential to understand what currency pair correlation entails.
In forex trading, we have safe currencies and risky currencies. Examples of safe currencies include JPY, CHF, and USD, while riskier currencies include MXN, ZAR, and AUD/CAD. Traders must gauge the risk of trading in forex to be on the right side when the currency pairs change. This alertness enables one to profit when they invest their money in the stock market.
Correlated Pairs in Forex Trading
You get a currency correlation when currency pairs are dependant on each other. This state happens when the individual currencies in both pairs are identical or belong to the same regional economy. An example is where a currency pair such as GBP/USD and EUR/USD contain USD on both sides. Additionally, Great Britain and the Eurozone are well-related economies that conduct partnered trading. These are the driving factors for a currency pair correlation in forex trade.
This statement implies you will usually see most pairs bearing the USD currency move in similar directions. The arrangement of the currencies in the pair will be on the same sides in most cases, and this signifies the correlation. However, not all correlated pairs have a strong connection. Some have a weak relationship due to fluctuating prices for different commodities in each economy.
Non-Correlated Pairs in Forex Trading
Non-correlated pairs move in independent directions, which are basically opposite each other. This tendency occurs when both pairs contain generally different currencies or appear from entirely different economies altogether.
An example comes from the GBP/NZD and EUR/USD. These currency pairs are non-correlated since they both lack a common currency, and the currencies operate in entirely different economies (UK, New Zealand, Eurozone, and the US). This tendency implies that the significant growth of one of the currencies does not affect the condition of another currency.
Trading of Currency Correlations
Forex traders utilize currency correlations to lodge their trades, increase their staking risk, or create value through commodity correlations, and there are several methods of trading currency correlations. Traders increase their earned profits through currency correlation in most cases. For instance, a trader may choose to place a long-term trade on two currency pairs like EUR/USD and GBP/USD since both pairs have a positive correlation.
The advantage is that currency pair correlation increases profits over several currency pairs. The downside is that this process involves a massive amount of risk. Adversely, traders may avoid risk by adjusting their currency values from a maximum size position, such as opting to split the trading size to 50% for both pairs.
The advantage of this setting is that you get to split the risk across several economies, thereby lowering the overall risk. The downside is that in this kind of transaction costs are much higher. Another way a trader can use correlation is by assessing the value of a pair of currencies. For instance, pairs of CAD gave a higher correlation to (WTI), i.e., Crude oil prices.
Currency Correlation and Commodities
Commodities have broad importance in forex trading. They regulate the flow of currency, and as such, a currency may rise or fall depending on the value of essential commodities. Investors therefore assess the overall flow of the economy based upon the prices of items in a given economy.
An example of a price and commodity relationship is on this negative currency pair correlation; Gold vs. SPY (US stock market). Here we see a negative correlation in that the rise of the price of gold leads to a fall in stocks. This condition implies that investors prefer holding an asset with less volatility to a riskier investment with high volatility. On the other hand, a fall in gold prices will initiate a rise in stock market prices.
This fluctuation would, in turn, increase the confidence of most investors to deliver their gold for investment in the stocks. However, this practice is usually a considerable risk since the market fluctuates within specific periods. It would be best if traders conducted a long-term observation of the trading outcomes to know where to place their purchase.
Once you understand how the negative and positive correlation comes into effect, you will also know the trading sequence in forex and you can easily predict the outcome of a given currency pair. The other way to determine the correlation effect is by using a calculator to calculate the final value. However, using a calculator requires that you follow all the necessary steps to find a correct value. A trader should also acknowledge the nature of their operating currencies since some are said to be safe currencies while others pose a risk to investors.
High-Risk Investment Warning: Trading foreign exchange on margin carries a high level of risk and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to trade foreign exchange, you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment, and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with foreign exchange trading and seek advice from an independent financial adviser if you have any doubts.