Currency Correlations and How to Use Them

Currency Correlations and How to Use Them

Learning what currency correlations are and how to best use them will be essential to your level of success as a forex trader. When it comes to trading forex, correlations are one of the most basic concepts that you have to learn. It’s all about how currencies affect each other, and it’s actually quite simple to understand and also to calculate.

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Because currency correlations are so important when trading forex and planning your investments, we thought we’d walk you through the concept.

What Are Currency Correlations?

In the world of trading, a correlation is the relationship between two securities. Hence, a currency correlation is the relationship between two currency pairs. It’s important that you understand that this is about currency pairs and not individual currencies since forex trading is always done in pairs.

The idea behind currency correlations is that all currencies are connected and that they affect each other. We will use an example to better describe what we mean.

Let’s say you want to trade USD/EUR since it’s a popular currency pair but also because you have somewhat of a connection to the currencies. Then you need to understand that the price of USD/EUR is affected by all currency pairs consisting of the same currencies. For example, USD/EUR is affected by USD/GBP, GBP/EUR, EUR/JPY, USD/CHF, etc.

You could say that all the hundreds of currency pairs on the forex market are connected in one way or another, which also means that all of our economies are connected.

Also, all correlations can be defined using a simple system that we’ll describe further below.

Examples of Currency Correlations: Either +1 or -1

The correlation between two currency pairs stretch from -1 to +1 with -1 representing two complete opposites and +1 indicates equals. Two currency pairs that are -1 will move in different directions 100 percent of the time, and a +1 currency pair will move in the same direction 100 percent of the time.

Meanwhile, a currency pair that is +0.95 will move in the same direction 95 percent of the time and a -0.95 will move in the opposite direction 95 percent of the time, etc. Naturally, this metric can differ based on time and a currency pair might have -0.85 for the last three months but -0.97 for the past year.

So, if USD/EUR and GBP/JPY have a currency correlation of +1, USD/EUR will rally every time GBP/JPY rallies and vice versa. If you see USD/EUR surging you could get a buy position for GBP/JPY and according to the concept of currency correlations you would make a profit.

However, if the correlation is negative and USD/EUR surges you would buy GBP/JPY in a sell position since the currency correlation indicates that GBP/JPY will do the opposite of USD/EUR.

Note that currency correlations, just like any investment metric and analytic method, aren’t completely accurate and that you need to study the market carefully before making a final decision.

Calculate Correlations on Your Own

Today, there are some services that can provide you with currency correlations for specific time periods, but we encourage all of you to learn how to calculate them on your own. Luckily, it isn’t very hard to calculate correlations. In fact, by using Microsoft Excel, you can avoid all the actual counting yourself.

To start calculating currency correlations, you need Microsoft Excel and the price data for the currency pairs that you are interested in. For this particular example, we’ll use USD/EUR and GBP/JPY. Most charting tools including several of the tools offered by our recommended forex brokers, offer a feature that allows you to download the historic price data for underlying assets. Otherwise, you will have to collect the price data yourself from a trustworthy currency converter.

With the price data saved you open a new Excel document and create two columns – one for each currency pair, i.e. column A for USD/EUR and column B for GBP/JPY. In the rows under you enter the daily price of the currency pair for the time period that you’re interested in, whether it’s 1 month, 3 months, or 2 years.

Underneath the rows with pricing data you put in the following formula =CORREL(A1:A50,B1:B50) where A1:A50 represents the total price data for USD/EUR and B1:B50 represents GBP/JPY. Adjust the last number to fit the number of rows you’ve used. If you only used 30 rows the formula would be A1:A30,B1:B30.

The sum that is provided by the formula is the correlation between the two currency pairs.

Easy, right? The best part is that Excel has a formula that has been developed for this specific purpose so that you don’t have to do all the calculating on your own. As long as you get the price data and remember the formula, Excel will handle the rest.

Using Currency Correlations as a Part of Your Forex Strategy

By now it should be quite obvious how currency correlations can help you plan your trading strategy, but we will still provide you with some examples.

The point of using currency correlations is to study two different currency pairs together in order to find trends to trade on. For example, if USD/EUR and GBP/JPY have had a positive correlation of 0.90 for the past year but the last two months it dropped to 0.65, you can assume that the correlation is changing and that they won’t mirror each other anymore. It also means you should wait with investing.

On the other hand, if USD/EUR and GBP/JPY has been at 0.65 for a year but increased to 0.90 in the last three months, you can assume that they will keep moving in the same direction, hence create an investment opportunity for you.

Disadvantages of Using Currency Correlations

Like all investment techniques and ratios, there are a few issues with currency correlations. In our opinion, there are two things you need to consider with currency correlations.

The first is that currency correlations, like most trading metrics, are based on trailing data and historic price data never paints a completely accurate picture of the future. Currency correlations are always changing, and you need to update your numbers as often as you can.

The second issue is that there are certain aspects that affect some currencies but not all. A spike in oil prices usually affects the USD and CAD since the American and Canadian economies are heavily influenced by oil, while EUR and JPY aren’t as affected by oil. Another example is if the United States would impose tariffs on Europe, the EUR would most likely be affected while the USD might remain untouched.

There is no way to avoid these issues, but by studying the market very closely, you can limit your risks. And as always, we encourage you to base your investments on more than one metric.

Summary of Currency Correlations

Currency correlations are a trading metric based on the relationship between two currency pairs. It’s used to calculate how two currency pairs work together in order to evaluate if they tend to follow each other or move in opposite directions. In turn, this information can help you predict in which way a currency is likely to move.

The best part of currency correlations is that it is easy to calculate and it requires minimal effort from you as long as you have access to Excel. All you have to do is get the price data for the currency pairs you’re interested in, copy and paste the data into Excel, and then let an Excel formula calculate the correlations for you.

As mentioned, currency correlations are an essential part of forex trading and something you should spend the time learning to understand. For many, using correlations is the difference between succeeding and failing as forex traders.