Understanding currency correlation and how to employ It in forex trading.
When you learn Forex for the first time, you must have known that trading in foreign exchange requires you to have great knowledge of fundamental events and technical indicators. Even though majority of traders are likely to focus on those two approaches, nowadays, more interest are drawn to proper risk management and trading psychology. This is where currency correlation is taken into account.
A Brief Explanation of Currency Correlation
When we are talking about currency correlation, this term is strongly related to risk management and is able to help you better comprehend the Forex market when trading. Understanding the relationship between currency pairs aids you to avoid overtrading and to employ your margin to grasp less wanted assets. This article will give details about what currency correlation is and how to use it properly.
• What Is Currency Correlation?
In financial terms, the word correlation refers to the numerical measure of the connection between two variables. The correlation coefficient range is between -1 and +1. In the Forex market, a correlation of +1 implies that two currency pairs are going to flow in the similar direction. Then, a correlation of -1 denotes that two currency pairs are going to move in opposing direction.
• The Forex Correlation Matrix
Just like other correlation types, Forex correlation is a term assigned to hint correlation between two currency pairs. When there are two data sets which are powerfully linked together, we can say that the two have a high correlation. A perfect correlation happens when two pairs go into the same direction which is very rare to occur in the Forex market.
• The Advantages of Using Correlation Matrix
Then, what makes it beneficial for traders to use this correlation matrix in
trading Forex? First, it can help to get rid of double exposure. In the Forex market, it is not recommended to open multiple positions with highly correlated pairs. Second, it can help to eliminate unnecessary hedging as well. When the correlation strength between dissimilar pairs found early, traders can prevent unnecessary hedging.
Next, using correlation matrix can hint high risk trades as well. Correlation between dissimilar currency pairs is able to indicate the number of trade strategy risk. For instance, there is negative relationship between USD/CHF and EUR/USD which limits taking positions in the similar direction. The explanation is that when you succeed on one trade, you tend to lose on the other one.
How to Employ Currency Correlation in Forex Trading
Now, how can we use this currency correlation knowledge to trade in foreign exchange? Generally, comprehending correlated currency pairs is crucial in deciding your portfolio’s exposure toward the market volatility. To use it for your trading advantage, you can take a correlation matrix which show positive and negative correlation which is available in the market at the time you view the matrix.
Whether the correlation is negative or positive, we need to remember that in the Forex market all currency units are traded as currency pairs. When you read correlation matrix, you might find that EUR/CAD and USD/CAD shows high correlation with CAD as the quote currency of both. This condition signal you to not trade both currencies in the same time since it shows double exposure.
The Bottom Line
In conclusion, currency correlation can be crucial information to learn when you want to avoid lose in multiple trading positions. This is because trading in two currency pairs which are powerful connected to each other are not recommended since you might lose in one of the pair. After all, don’t stop to learn Forex if you are planning to survive and master the Forex market.