The Ultimate Guide to Forex Correlation
The Fundamentals
Before we get into pairs trading or hedging, let’s understand the basics of correlation and how it is used.
Correlation in Forex: Definition and Significance
What is Correlation?
The very basic definition of correlation is a statistical measure between two currency pairs that shows how and to what extent the price movements of one are related to the other.
Pairs move in the same direction in perfect sync
Price actions are not related in any meaningful way
Pairs move in opposite directions consistently
Reading a Correlation Number
If r=1, pairs are perfectly positively correlated, meaning if one moves 10 pips up or down, the other always moves 10 pips up or down in perfect sync.
If r=0, the two are not correlated at all, meaning their price actions are not related and do not move in any meaningful way in relation to each other.
If r=-1, they are perfectly negatively correlated, meaning if one pair goes 10 pips in one direction, the other always moves 10 pips in the opposite direction.
Fractional Correlations in the Real World
Remember, forex correlation is dynamic, the numbers always change. In the real world, there are very few “perfect” correlations. Correlation in forex is almost always fractional.
Why bother?
Forex trading is not just learning to read charts and enter and exit orders. In the markets, your money is constantly at risk. You can’t avoid risk, but you must actively manage it. Forex correlation allows you to do this and more.
How to Trade Using Forex Correlation
Three ways traders use forex correlation:
Avoiding overexposure by understanding correlated positions
Using correlation as a filter for stronger trade signals
Using negatively correlated pairs to offset risk
Risk Management (Avoiding Overexposure)
The Biggest Danger: Accidentally Overexposing Yourself
Accidentally overexposing yourself is one of the fastest ways to blow your account. It is one of the reasons it is so easy to lose trading leverage and have those losses spiral out of control.
Say you are long 1 standard lot EUR/USD, a buy signal just triggered on GBP/USD, and you open that as a new 1 standard lot trade as well. Each position is a $100,000 bet. But there’s one problem: these two pairs typically have a correlation of around +0.80. This means you’ve not opened two trades but 1.8 trades on the exact same macroeconomic idea (the US Dollar is weak and must strengthen). If the Dollar DOES strengthen, both positions will be losing trades at the same time.
How to Spot and Avoid This?
The only way to know for certain is to actively monitor the correlation between the pairs you trade. Trade correlated pairs without checking, and it will bite you eventually.
Before you open a trade, do a quick two-second check on correlation. If your new signal is in a correlated pair (we generally mean correlation above +0.70 or below -0.70), you have two choices:
- Hedge: See later in the guide.
- Reduce both sizes by half.
Choose the Trade with the Better Set-Up
Alternatively, if both pairs have positive signals and you only want to trade one, you can simply choose the pair with the better set-up (e.g. stronger trend, higher ADX, lower RSI, more bullish, larger candle pattern, etc.).
Trade Confirmation
Correlation as a Filter
There is one other commonly used application of forex correlation which, while a little more advanced, is well worth learning. Correlation is a natural filtering tool for signals, helping to avoid false breakouts or drawdowns by waiting for confluence before taking a trade.
AUD/USD has formed a bullish flag pattern. A clear breakout is forming. However, the correlation matrix shows that GBP/USD, a closely correlated pair, is flat and below the upper resistance line of its own flag pattern. As such, AUD/USD breakout looks weak. Maybe we wait for GBP/USD to break out as well.
AUD/USD is up as per above, but this time NZD/USD, also strongly correlated to AUD/USD is rocketing upwards. This is a very strong confirmation signal that the move is not isolated but rather driven by strong broad-based USD weakness or commodity currency strength.
Hedging
Is Hedging a Trading Strategy or Risk Management?
Hedging is almost always a defensive move, a way to limit risk. So it is the opposite of a strategy. The fact that it often costs money and caps potential profits are two of the reasons most professional traders frown on it, especially in the spot Forex market.
However, despite the common wisdom, some forms of hedging are extremely useful and can dramatically improve your risk management as well as trade selection and portfolio management. Knowing the basic concept and how to use it properly is a key step in trading risk intelligently and proactively.
The act of opening positions in different markets or instruments that are expected to move in opposite directions to protect against potential losses.
Negative Correlation as a Proxy Hedge
In terms of Forex, it usually means opening positions in currency pairs that are expected to be strongly negatively correlated.
You own a long EUR/USD position (you bought EUR/USD and are now waiting for the price to rise). You are worried about an important US inflation data release that is coming up in 1 hour which could cause the pair to crash if it’s bad. The solution: open a small, offsetting (strategically sized) position in another pair that is expected to move the other way if USD/CHF falls, that is, to rise, if EUR/USD falls. EUR/USD and USD/CHF are usually strongly negatively correlated.
Trade Size Is Key
The key to hedging with a proxy pair is sizing it properly to offset the open position without unnecessarily reducing profits. With a -0.80 correlation, the two pairs move in opposite directions 80% of the time. A 0.1 lot USD/CHF hedge position would therefore be expected to offset around 0.8 lots of EUR/USD.
Spot Correlation
Timeframes and a Warning
A word of caution: you need to be conscious of the timeframe you are using when looking at correlations. The correlation between two pairs will almost always be different on a 1-minute, 1-hour, 4-hour, and daily chart.
Use Short and Long Timeframes
Medium-term is most important. A general rule of thumb: Use 20- and 100-day charts to determine overall correlation. Use short timeframes to find short-term opportunities or confirmations.
Correlation Matrix: Practical
Finding Currency Correlations
The most common way to actually use forex correlation in trading is with a correlation matrix. It will become your go-to tool, just like volume indicators, support/resistance levels, trendlines, and other “fundamentals.”
Search for “correlation matrix” in the indicator menu of TradingView, MT4 or MT5, or look it up in your broker’s charting platform. The table, or matrix, will typically list forex instruments across both columns and rows. At each intersection is the current correlation coefficient between the two pairs (always changing).
Almost all tools will have a “multi-add” button that brings up a text box where you can enter multiple symbols, each on a separate line, then hit “enter” and it will batch-add them all in one go.
By the way, even though it’s not technically a currency, AUD, NZD, USD/CHF, etc all closely track key commodities and stock indices. AUD and NZD track the NZD/USD, AUD/USD, and NZD/USD. Add them to your list.
Finding Uncorrelated Currency Pairs
How to Filter or Find Uncorrelated Pairs?
Again, not everything is positive correlation, and many retail traders like to trade uncorrelated pairs to diversify their portfolios.
Look for coefficients near zero. Look in a pair’s extended history to identify long stretches of near-zero correlation. This is quite rare, and happens most often between pairs where USD is in the middle (EUR/USD & USD/CHF or GBP/USD & USD/CHF, AUD/USD & USD/CHF, and EUR/USD & GBP/USD, EUR/JPY & GBP/JPY, and so on.
Why Is This Useful?
It is a very simple way to quickly diversify a Forex portfolio. Highly correlated pairs are like two separate bets on the same outcome, and uncorrelated pairs are two separate bets on completely different events.
Easy Portfolio Diversification
Uncorrelated pairs means you could in theory open a long and a short at the same time, double your position size, and if one goes down the other is much less likely to go down with it. This is a very simple example of how easy and intuitive it can be to use correlation to trade smarter.