Understanding Correlations Between Forex Pairs

Filed under: Learn Forex Trading |

There are a lot of hidden traps in the world of forex trading. One of these hidden traps is the way in which some forex pairs are correlated; meaning that you can in effect, end up risking more than you intended. Let me explain…

 

Forex pairs are correlated in many complex ways. On a basic level, for example, the GBP/JPY is correlated to the USD/JPY and the USD/GBP, simply because it is a half of these other pairs. This is obvious. However, there are also more complex forces at work, meaning some pairs move like a mirror image, and while one goes up, the other goes down.

 

Figure 1.

Figure 1 shows a correlation table for the EUR/USD pair (where 1 means the pairs move in the same direction 100% of the time and -1 means they move in opposite directions 100% of the time). As you can see, some pairs are highly correlated. Over the course of a year, the EUR/USD and the USD/CHF pairs move in opposite directions 97% of the time. This is an almost perfect inverse correlation! This is why I currently stated my reservations over have a long and a short trade open on the EUR/USD and the USD/CHF pairs, as these are essentially a mirror image of each other, and in effect, it is doubling my risk.

 

If you had, say, six or seven positions open on pairs that are all highly correlated, if the market moves against you, you could find that you will be carrying a very heavy drawdown. If you understand how the different pairs are correlated, then you will be able to better control your drawdowns, and limit your risk. And if you are not sure, then simply never have more than one trade open at any one time!

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