Correlation is a very important factor of Forex market as in Forex market we do not trade in a single currency but we trade in a currency pairs thus the relation between currencies plays a very important role in the movement of the market. To be a successful Forex trader one must study the correlation between currency pairs as it is a very effective tool which not only helps a trader to select those currency pairs which have the highest possibility to generate profits but it also helps a trader to evaluate his portfolios sensitivity to market volatility.
What is Currency Correlation?
As we know correlation is the statistical measure of the relationship between two variables and this is the same in the forex market, currency correlation also represents the relationship between two different currencies. The correlation is expressed in between -1 and +1 where -1 implies that the two variables are negatively correlated and moves in the opposite direction and +1 implies a positive correlation which will state that the two variables or in forex market the two currency pairs tend to move in the same direction.
In the forex market we trade in currency pairs, we sell a currency and in exchange, we buy a currency thus the trade depends on the movement of both of the currencies. For example if a trader believes that the value of the British pound will increase and the Swiss franc is going to lose its value then he will simply buy the GBP/CHF pair as by doing this he is going long on GBP and shorting the CHF against the GBP but on the other hand if the correlation between GBP/USD and USD/CHF is +1 then he should not take this trade in this situation the value of the pair GBP/CHF will not move much as both of the currency GBP and CHF will move on the same direction which will result in a extremely slow movement. And the pair GBP/CHF is a derivative of GBP/USD and USD/CHF pairs.
How to make and maintain the correlation table
Making a correlation table is quite a simple process and it can be done through the use of a spreadsheet program like Excel. All you need to do is download the historical data of the currency pairs and transport it to Excel and use the correlation function which is CORREL(range1, range2).
We all know that the correlation in forex pairs do change time by time so we always need to update our correlation table on a regular basis. Although it is not necessary to update your correlation table every day, you can update the table once a month or in case of any big movement in the market to keep your correlation table productive.
How to use your correlations table
Correlation table helps you do decide which pair to trade as it gives you a clear idea of the pairs which cannot be clubbed because of their positive correlation which can result in a flat movement.
For example, if the correlation tables show a -1 correlation between GBP/USD and USD/JPY which means they both move in the opposite directions having a long position in both of the pair equal to having no positions as both will nullify the profits of each other.
Correlation also helps in the diversification of your portfolio as a trader can use an imperfect correlation between tow currency pairs to diversify his portfolio. And correlation plays a very important role in the selection process of the currency pair to hedge an open position if there isn’t any opportunity in the same currency pair.
In that sense no matter what is your motive weather is diversification of your portfolio or selecting a most reliable and profitable trade or even hedging you position correlation plays a very important role. Because of that a forex trader should always keep the correlation table on a check and use it on a regular basis to make profits out of the market.
The Bottom Line
In order to be a successful Forex trader, one must understand the concept of currency correlation as it is a very powerful tool which can be used in different situations and using a correlation table is also very easy. A correlation table is a handy tool which has tremendous potential. As we know that some currency pairs tend to move with each other, while others currency pairs move in opposite directions so learning about the currency correlation helps Forex traders in making a well researched and informed trading decision and it helps the trader to manage their trading portfolios efficiently in an ever-changing Forex market.