Currency Correlations Change!
The forex market is like a schizophrenic patient suffering from bipolar disorder who constantly eats chocolates, experiences extreme sugar highs, and has volatile mood swings all day long.
We’re not even exaggerating.
Although currency correlations between currency pairs can be strong or weak for days, weeks, months, or even years, they do eventually change and can change when you least expect it.
The strong currency correlations you see this month may be different next month.
For the most part (thanks, USD/JPY!), they’re different across the board, changing from one-time frame to another. And they change in all directions.
❗️The lesson here is that currency correlations do change, and they change frequently.
They can change by a drastic measure in a short time frame, as is apparent by looking at EUR/USD at the 1-month and 3-month intervals.
That’s a big swing!
Because of the constant sentiment shifts in the currency market, make sure you’re aware of the current currency correlations.
For example, over one week, the correlation between USD/JPY and USD/CHF was 0.22. This is a very low correlation coefficient and would indicate that the pairs have an insignificant correlation.
However, if we look at the three-month data for the same period, the number increases to 0.52 then to 0.78 for six months, and finally to 0.74 for a year.
In this example, you can see that these two pairs had a “break-up” in their long-term correlation relationship. What was once a strongly positive association in the past has extremely weakened in the short term.
If they were a real couple and had only dated a month or less, they would’ve thought they were incompatible.
Little do they know, the passion will start heating up later!
If you look at EUR/USD and GBP/USD, here’s an example of the extent to which currency correlations can change and jump around.
The one-week period shows a very strong correlation with a 0.94 coefficient!
…But this relationship severely deteriorates in the one month, dropping to 0.13, before improving again for its three-month period to a solid 0.83, then deteriorating again to a weak correlation in its six-month trailing period.
When you are simultaneously trading multiple currency pairs in your trading account, the most important thing is to make sure you’re aware of your RISK EXPOSURE
You might believe that you’re spreading or diversifying your risk by trading in different pairs, but you should know that many of them tend to move in the same direction.
By highly correlated trading pairs, you are just magnifying your risk!
Correlations between pairs can be strong or weak and last for weeks, months, or even years. But always know that they can change on a dime.
Staying up-to-date with currency correlations can help you make better decisions if you want to leverage, hedge, or diversify your trades.
A few things to remember…
Tips On Using Currency Correlation In Forex Trading Coefficients are calculated using daily closing prices.
- Positive coefficients indicate that the two currency pairs are positively correlated, meaning they generally move in the same direction.
- Negative coefficients indicate that the two currency pairs are negatively correlated, meaning they generally move in opposite directions.
- Correlation coefficient values near or at +1 or -1 mean the two currency pairs are highly related.
When you find yourself wanting to trade two highly correlated pairs, it’s okay if you take both setups.
Just make sure you have rules in place when you trade correlated pairs and always stick to your risk management rules!