Correlation is a very important strategy that many traders and hedge funds have used to make profitable trades. The concept behind correlation is that in currencies operate in pairs. When a currency pair such as EUR/USD goes up, there could be a possibility that a pair such as GBP/USD goes down. Correlation therefore looks at these relationships and how traders can take advantage of them.
Traders use correlation for a number of reasons. One, they use correlation to eliminate counterproductive trading. This is where traders might be tempted to trade positions that eventually cancel one another. A good example is on the EURUSD and USDCHF pairs which move in the opposite direction most of the time. When EURUSD is moving up, chances that USDCHF will be moving down are very high. Placing a buy position in the two pairs is therefore counterproductive and can lead to huge losses.
The second reasons why you should use the correlation strategy is to leverage on your profits. When using the strategy, you have a chance to double-up on positions which leads to maximized profits. In many cases, the EURUSD and GBPUSD pairs have a very strong correlation. The GBPUSD mostly follows what EURUSD does. Therefore, going long the two pairs will lead to more profits because of leverage.
Understanding correlations also helps in diversifying and hedging out a portfolio. Diversification has for long been identified as a key way of minimizing losses. That is the main reason why successful traders such as George Soros and David Einhorn have taken positions in many companies. By using correlation, it will help you identify the best positions to go long, short or both. Hedging also helps to minimize losses.
A trader using the correlation strategy needs to understand a number of things. One, he needs to understand the procedure of calculating correlation. Secondly, the trader needs to understand how to interpret the results from the correlation. Finally, the trader needs to understand how to incorporate correlations in his trading strategy because this data will not always be adequate to determine a sell, buy, or hold position.
How to calculate correlations
Calculating the correlation between currency pairs might seem difficult. However, doing this is not as difficult as it seems. All you need to do this is Microsoft Excel and historical data. Historical data is available for free in most charting platforms. Many data vendors also provide the data for a fee.
Once you have calculated the data, you need to download it and export it to Excel. The best data to use to calculate correlation is a combination of 1 year, 3 month, and one month data. You can also narrow it down to weeks and days. In Excel, you should use the =CORREL (range 1, range 2) function. Since the correlation data changes, you should update it on a regular basis.
Another strategy to get the correlation data is by the use of websites and brokers who provide the information for free. In Google, just search for currency correlations and you will find the information.
Interpreting the correlations
Having the correlated data is not enough. Interpreting it is the most important aspect in trading. The table below will help you a great deal in interpreting the data.
In the table above, you can see three main areas: Perfect positive correlation, perfect negative correlation, and no correlation.
In perfect correlation, the two currency pairs are most likely to move in the same direction. When the correlation is a perfect negative, the two currency pairs will move in different directions. If the correlation is 0, then no correlation exists.
The following table is an example of an automated correlation table.
From the above table, a number of things are evident. One, the correlation figures are never the same. In the AUDCAD pair, the 1 hour correlation figure shows a negative correlation while the daily, 1 week, and 1 month pairs are positive correlations. In addition, it is evident that a perfect correlation of 1 is never possible.
Therefore, it is very important to understand how currency pairs move in relation to one another. This will help you understand the exposure of each trade that you enter. Some pairs move in tandem with one another while others move in direct opposites. By having a good understanding of these issues, you will be at a good position to achieve success by avoiding mistakes that are common to traders.