Understanding Simple Correlations and the
Currency correlation in forex
Novice traders often have a tendency to trade just about any currency pair that moves. Typically they'll have
their chart package open, they'll be flicking through all the: major pairs, the minors, some of the more exotic
pairs and suddenly they'll witness movement on, for example, the pound versus the New Zealand dollar GBP/NZD.
They'll take the trade, it may or may not prove to be successful, but they've taken it because of a sudden price
action movement, which may have (temporarily) reduced the spread, albeit marginally.
However, the spread on such a currency pair is never tight. A typical spread/quote of circa 5 pips is not uncommon on this pair and in many ways it never pays to take trades on such pairs,
when more likely far better opportunities exist. How to identify the better risks and wait to take the
opportunities offering better value, requires a range of skills, some of which we'll now discuss.
|Understanding correlations between different currency pairs is
crucial to successful
The concept of correlation and how to understand
Understanding correlation as a concept and how to trade it, is a subject which requires far more in depth
analysis than can be contained in single articles, but we'll make brief reference to the phenomenon in this
article, given its critical value to the subject matter.
So let's concentrate on the pair we originally mentioned; GBP/NZD. If our method, our trading strategy, is
alerting us to a manual trading opportunity were this currency pair is concerned, then what does it
indicate with regards to both sterling and the kiwi? Can we quickly identify, through a form of
cross-referencing, what's happening to sentiment concerning both currencies and therefore identify a better
trading opportunity on the major pairs? Will we be quoted a much better spread, with far less likelihood of
experiencing slippage, therefore we'll get filled at the price and spread very close to that we've seen quoted
on our platform?
Currency correlation constantly changes
A suggestion as a comparison is that we should quickly observe the price behaviour of GBP versus: yen, euro and
U.S. dollar. Similarly, we should cross reference the kiwi's price action versus the same peers. It must be noted
that correlations are not a permanent feature of the FX markets; it's by
no means a given fact that, for example, if EUR/USD rises USD/CHF falls, despite it representing perhaps the most
obvious negative correlated move in forex markets. Correlation tables, of which there's many free to access or
download on the internet, change constantly as currency sentiment constantly oscillates.
If we're witnessing the pound rising versus the kiwi, is it also rising versus the: Euro, Aussie dollar, yen and
the U.S. dollar? If the kiwi is falling versus the pound, is it also falling versus the same peers? Quite simply;
does a better trade opportunity exist trading sterling or kiwi versus its peers, by trading a different currency
pair, with historically better spreads and for more liquidity, therefore significantly reducing the potential for
slippage? The answer may centre around the price action behaviour of the U.S. dollar.
By value, according to BIS (Bank of International Settlements) data published in December 2016, the U.S. dollar
accounted for 87.6% of trade with its peers. The euro 31.3%, yen 21.6% and sterling 12.8%. All the data was based
on 200%, given each currency always traded as a pair.
Establish a trend
Novice traders would therefore be advised to always look towards the major traded currencies to establish a
trend, as opposed to attempting to find that rare "needle in a haystack" trade. Traders should always compare the
correlations, reference the fundamental data which may have caused a move, but perhaps always look to see if a
better opportunity exists with the U.S. dollar. Trying to curve fit our plan to trade other pairs not involving the
dollar, can at times prove to be both frustrating and fruitless in equal measures. In the forex market it really
is, "all about the Benjamins*".
*Benjamin refers to the slang name for the U.S. 100 dollar bill. It displays an image of president Benjamin
Franklin on the reverse.