Know Currency Correlations
Currency pairs are interrelated in the forex markets. As a forex trader, understand that the price action of each currency pair is not independent of other.
Different currency pairs move relative to one another. You need to understand that different currency pairs are correlated. Correlation can be positive or negative.
Knowing how strong this relationship is and its direction can help you a lot in developing your trading strategies. Correlation analysis has the potential to become a great trading tool for you.
Correlations are numbers that range between +1 and -1. These numbers are calculated based on past pricing data between different currency pairs. They can provide you with information that can maximize returns, minimize risk and avoid counter productive trading.
Lets take an example. Suppose USD/JPY and USD/CHF had a positive correlation of +0.83. This number is close to +1. It means that both the pair move together most of the time.
Since both the pairs move together, if you are trading USD/JPY and USD/CHF at the same time, it will double up your position if you go long or short on both at the same time. In other words, if you lose a trade on USD/JPY, the chances are that you will also lose the trade on USD/CHF 83% of the times.
Take another example. Suppose EUR/USD and USD/CHF have a negative correlation of -0.9 in the past month. Both the pairs are moving in opposite directions. If you go long on one, it is not a good strategy to go short on the other. It will only double up your position and increase your risk.
While investing in two currency pairs simultaneously, try to choose such pairs that have correlations close to zero. Zero correlation means the two pairs are almost independent of each other and mutually exclusive.
Keep this in mind that forex markets are constantly changing. These correlation numbers also keep on changing. It is a good idea to calculate the correlations of the pairs that you invest in on monthly basis.
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