Using Currency Correlation in practice
Understanding of a relation between different currency is an essential element of a profitable trade on finance markets. Intermarket correlations exist between different sectors, for example between commodities and currencies, between stocks and bonds etc. The skill regarding finding and using correlations properly helps to increase the possibility of a successful trade.
This article will give answers to the following questions: what is the correlation? How to use it? What moments are worthy to pay attention to?
What is correlation?
Correlation — is a term, that is generally used to denote a relation. In statistics correlation is a relation of a few random values. Herewith, the change of one or a few values from the totality implies a systematic change of other value or values.There are few ways to calculate the correlation coefficient. Depending on the type of the processed values parametric and nonparametric correlation exponents can be used. The most widely used nonparametric exponents are Spearman's rank correlation or Kendall’s tau. In reference to markets the term of correlation means parametric Pearson correlation coefficient. Those who prefer algo trading can learn the mathematical exposition themselves, any book of statistics is full of such info.
For traders, correlation shows how two financial instruments – currency pairs, stocks, commodities etc – moving in one or opposite direction. It shows the fact of the presence of connection between them.
Positive correlation. If two instruments have positive correlation - they move in one direction. For example, EUR/USD and EUR/CAD usually moves in one direction because in both cases the major currency is EUR. USD and CAD usually behave the same.
Negative correlation. If two instruments have negative correlation, they move in opposite directions. For example, EUR/USD and USD/CHF. It happens because in this example USD is the quoted currency, and in the second case it is basic.
How the correlation is measuring?
There are few ways to measure the correlation:
- In the form of a table. Exists as a method of calculation by historical data in MS Excel and different online services. But it would be easier to calculate it in PTMC platform, using the special plug-in for calculating the correlation coefficient and imagine data in a table view. Download plugin here. Use installation guide to install PTMC extensions properly.
- Using technical indicators to determine the correlation coefficient directly on the chart. For instance, you can use Correlation indicator
How to use correlation?
While trading a few currency pairs the risk can be thoughtlessly increased. For example, The correlation coefficient for EUR/AUD and EUR/JPY is 85. Simultaneous long position opening for EUR/AUD and EUR/JPY means risk increasing. As soon as correlation shows that hey are moving in the similar directions, it's reasonable to imagine that EUR/AUD goes low. That would mean good chances for EUR/JPY to behave the same, that would result in two stop losses.
Proper usage of this knowledge can diversify or hedge the risks.
The importance of the close to the currency pair level can also be proved that way. Let's take USD pairs as an example. A/USD is near the significant resistance level and there is a trade idea to open a long position from that level. Knowing that A/USD has a positive correlation with B/USD and a negative with USD/C and USD/D it is good to start keeping an eye on these four. If B/USD is also near the significant resistance level and USD/C and USD/D are near the support level — that proves the significance of the current level, because the roots of the situation go deep into the power of USD.
If three pairs are moving randomly or trading on the side, then it can be understood that this situation is not bounded to USD, but is relied upon some negative events in the country, for example. So, it is better to analyze the situation and lower the position size.
Also, the strategy of couple trading is worth mentioning. It is fully based on the correlation dependence between two instruments. But this is better to be discussed in a separate article.
What are the most significant correlations?
- Correlations between currency pairs
In general, pairs with same currencies has a positive correlation. For example, pairs with USD as a quoted currency with positive correlations: EUR/USD, AUD/USD, NZD/USD, GBP/USD.
It also works for some pairs with USD as a base currency: USD/CAD, USD/JPY, USD/NOK, USD/MXN, USD/SGD, USD/SEK.
Of course, it also works with other currencies, like EUR or GBP.
Here is a screenshot with 4 currency pairs with EUR as a base currency. In general, the price moves the same way.
- Currency USD and DX (USD index)
While trading the USD pairs it is good to keep an eye on dollar index behavior (DXY). This index helps to understand how strong or weak the USD is at the moment. While watching the increased DXY volatility trader should keep in mind that it will influence another index currencies. Here we only need to choose the direction of the instrument's trade.If the dollar is base currency (common view USD/X), then dollar's index and currency pair will have a positive correlation and move in one direction. If the USD is quoted currency (common view X/USD, also refers for futures) than correlation will be negative and charts will move in opposite directions. Also, USD index can be used to prove key zones of support and resistance, which helps to make the best trade decision.
- Currencies and commodities
CAD and AUD are the most dependent on the commodities among the world's currencies. Canada is a large producer and importer of the oil and Canadian economics depends on the oil prices a lot. That's why CAD and oil have positive correlation. So, it is recommended to pay attention to oil's behavior while trading currency pairs with CAD.
Australia is significant producer and importer of the gold and Australian economics depends on gold mining. Therefore, the prices for gold and AUD will move in similar directions.
Similar examples could be seen between the futures and forex pairs. Also, investors risk hedging can be discussed. For example, JPY and SEK are considered as "safe harbors". So, why don't we look for some interesting correlations with these currencies, futures for them and share it in the comments?
Triangle of currencies
Therefore forex instruments include two currencies, we can build so-called currency triangle. For example, EUR/USD, AUD/USD and EUR/AUD. By multiplying prices for EUA/AUD and AUD/USD we can count the price of EUR/USD price without looking at the chart.
This feature allows understanding the currency strength. Watching the currency triangles allows understanding about which of three currencies is stronger or weaker. Usually, if two couples are in trend, the third one is in range.
There are parts of mentioned pairs for April-August 2016 on the screenshot. EUR/AUD and AUD/USD has had a well seen trend, but EUR/USD was on the side. In such way, currency triangle helps to make more balanced trade decisions and understanding the behavior of the instrument on the more professional level. It is allowed to select the pairs which are in trend or trade on the range border. Share your examples in the comments.
Worth understanding that the currency triangle is not the end here. Next step is a currency cluster. It shows the relation of one currency to a set of other ones. Imagine dollar index as an example here. The PTMC trading platform includes cluster indicators, like CCFp and CC. The advantage of these indicators is the ability to select the most perspective trading instruments, see the origin and decline of the trend. The next article will tell much more about this kind of indicators.
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