Correlation in the Forex market is simply the effect currency pairs like EURUSD and GBPUSD have on each other. If you have a Forex correlation code or system you can use this to your advantage when trading currencies. Once you know the correlations between different currencies you can use this on an ongoing basis to control your exposure and risk. How Do Forex Correlations Work? An easy way to understand this is by actually looking at an example. If we take two currency pairs:
Both these currency pairs have exposure to the USD, so if you were trading for example, GBP/JPY then you could consider it a subset, offshoot or derivative of the two pairs listed above. Using this knowledge you can take advantage by understanding that some currency pairs move in different directions while others move in the same direction. Take a Look at The Correlations Below you will see the a table which outlines the currency correlations over one month:
How To Read The Correlation Tables You can see in the first table above for the EUR/USD that the AUD/USD, GBP/USD and NZD/USD had a positive correlation that had allot of strength behind it. In fact, looking at NZD/USD you would say that if the EUR/USD rallied they NZD/USD would rally 94% of the time. However, one thing to note is that if you looked at this over a longer period you’d find this correlation to diminish in strength (to around the 50% mark over 3 months in fact). Opposing this, you’ll see that the USD/CHF had an almost perfect negative strength correlation with -99%. From this you can take that almost 100% of the time when the EUR/USD rallies the USD/CHF will have a massive sell off. We know that this figure, as opposed to the NZD/USD example in the paragraph above, is about the same when you extend the period to 3 months or more.
One important fact to remember is that currency correlations don’t always remain the same. If fundamental changes occur between or within countries then you can see a complete flip of the way the currency correlates.