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What is correlation in the Forex market?

What is correlation in the Forex market?

What is correlation in the Forex market?

Correlation (from Latin correlatio - ratio, relationship) - the relationship of two random variables. A change in one value leads to a change in the other and vice versa. A measure of the level of relationship between two random variables is called the correlation coefficient.

When we are talking about correlation in the Forex market, wel mean the correlation level between two or more trading instruments. The correlation of exchange rates is an important indicator by which traders are building their trading strategies.

What types of correlation exist in the Forex market?

There are several types of correlation: direct, indirect and zero correlation.

  • Direct or parallel correlation means that a change in the rate of one trading instrument causes the movement of another instrument in the same direction.

  • Indirect or mirror correlation means that a change in the rate of one trading instrument causes the movement of another instrument, but in the opposite direction.

  • Zero correlation means that changes in the rate of trading instruments do not depend on each other in any way.

By understanding the level of direct or indirect correlation between trading instruments, traders can predict changes in the rates of these instruments. It is also important to define the time gap between those changes.

If trading instruments move in the same direction with a short time interval, then the correlation coefficient will tend to 100%. If the trading instruments change in different directions, then the coefficient will become tend to -100%. Therefore, the lower the correlation coefficient, the lower the dependence between trading instruments.

Direct correlation example: GDP/USD and EUR/USD:

Indirect correlation example: GDP/USD and USD/JPY:

How to use correlation in trading?

Taking into account the correlation dependence of the two currency pairs, traders can hedge their positions, thereby decreasing potential risks. On the other hand, it is important to understand that simultaneous transactions in currency pairs with a high correlation coefficient increase the risk of losses, since in an unfavorable market situation, all your transactions will turn out to be negative. For example, when opening the same trades on AUD/USD and NZD/USD, your risks are doubled, since the Australian and New Zealand currencies have a direct correlation with each other. A similar situation can arise when trading multidirectional positions on trading instruments with a mirror correlation.

Understanding the correlations of trading instruments will allow traders to avoid wrong decisions when opening new trades. Correlations are especially important for traders who use medium-term and long-term trading strategies.

Article last updated: 2022-05-11

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