How to trade using currency pairs correlation

August 12, 2020

Forex pairs correlation and how to trade itJana Kane

The trader’s success can be assessed by many parameters: profitable trades, account balance or total deposit. However, I think the trader’s professionalism is determined by one very important indicator - the ability to calculate and analyze statistical indicators.

The article covers the following subjects:

The understanding that currency pairs are interconnected, as well as the ability to find this connection and use it will provide reliable protection for your deposit.

What is currency pairs correlation?

The world currency market is a system of interconnected elements. Change in some leads to the reaction of others and vice versa.

This gigantic machine lives by its own laws. If you know them you can predict the movement of currency quotes and earn money on the fluctuation in the exchange rate. The phenomenon of currency correlation reflects the interconnectedness of the currency pairs, the synchronism of this process.

The correlation value shows how similarly two specific currency pairs fluctuate. The higher the correlation index, the more synchronous the change. Such currency pairs move together as if in unison. There is also an inverse correlation between currency pairs reflecting the movement of quotations in opposite directions.

Correlation is the ability of one trading asset to repeat the directional movements of another instrument.

We can see a similar phenomenon in the financial markets with gold and silver, or various grades of oil and its refined products.

Theory and examples of Forex currency correlation

Correlation between currencies is a phenomenon that occurs when price movements of several currency pairs are similar. There are two types of correlations: positive and negative

Positive correlation is a correlation in which price movements of currency pairs change in the same direction. The charts of 2 similar instruments have the same direction (for example, in both cases, the trend is up).

Negative correlation is a correlation in which price movements of currency pairs change in different directions. That is, the uptrend of one instrument is a “mirror reflection” of the chart of the second instrument, which is directed downward.

An example of a positive correlation (direct correlation) is a situation in which the expectations of traders are similar, as in the case of the [EUR/USD][1] and the [EUR/GBP][2]. We can see that the forex pair correlation chart coincide:

![LiteForex: Forex correlation pairs | How to trade using currency pairs correlation][3]

An example of a negative correlation (inverse correlation) is a situation in which the expectations of traders are opposite, as is the case with the [EUR/USD][1] and the [USD/CHF][4]. In this figure, we can observe a mirror image of currency pairs:

![LiteForex: Forex correlation pairs | How to trade using currency pairs correlation][5]

The strength of the correlation is measured in percent (or fractions): 100% (or 1) is the highest degree of correlation of two assets.

To determine this value, traders use the Pearson formula. First, they select a certain set of price values of two assets - X and Y. Then they determine the average values of X and Y on it, add the product of the deviations of each value of the set from its average, and divide them by the product of the standard deviation.

For two instruments with prices X and Y, the correlation coefficient formula is as follows:

![LiteForex: Forex correlation pairs | How to trade using currency pairs correlation][6]

On the Forex market, the correlation of currencies was determined at the stage of its formation, when instead of using the “gold standard”, national currency rates were tied to the US dollar.

It is believed that major currency pairs have a greater degree of correlation among themselves than minor ones.

What can a currency correlate with?

With other currencies. Currencies can correlate with each other, as in our example. We will observe the correlation of two currency pairs, which include one common quoted currency.
With indices. This should be clear too. Changes in indices lead to changes in a particular currency. For example, we can recall that the US dollar correlates well with the S&P500 index.
With commodity assets. Commodity assets include everything that countries export and import. These are oil, gold, coal, aluminum, etc. You have probably deduced that there is a strong correlation between the Canadian dollar and oil. A correlation is also observed between the Australian dollar and gold.

How to calculate currency correlation?

There are special calculators where you can select currency pairs and calculate the correlation between them. This is just a couple of mouse clicks in the browser. Thankfully you don’t have to calculate it manually using the complex formula that I gave above. The currency pair correlation calculator will show the value of positive and negative correlation.

A direct correlation is shown with a “+” sign, or with no sign at all.

Inverse correlation is shown with a “-” sign.

Note that there is a strong and weak correlation. The stronger the correlation, the more similar the price movements of the two instruments. The weaker the correlation, the less similarity. The value of a strong positive correlation is closer to “1”. Or, respectively, to “-1” for inverse correlation. The non correlated forex pairs is closer to “0”.

Forex pair correlation calculator

The currency pair correlation calculator will show the value of positive and negative correlation. Calculate forex majors, minors, and cross currency pairs correlation here:

You can find many websites that calculate the forex pairs correlation table. However, there are practically no trading tactics based on correlation.

Forex correlation trading strategies

The correlation of currencies through the US dollar can be used in two types of strategies:

After finding two correlating currency pairs, one of them is used to track signals that can indicate the direction of future movement in the second pair.
Using movement discrepancies (inverse correlation), traders sell one pair and buy another at the same time, or use cross-rate currency correlation. In this case, the number of points by which the two assets have diverged becomes the trader’s profit when their movement coincides again and the correlation is restored.

Example No. 1

Let’s look at an example of such currency pairs like EUR/JPY (Euro and Japanese Yen) and AUD/JPY (Australian Dollar and Japanese Yen). In both cases, the quoted currency is the Japanese yen. It’s strengthening on the market (price increase) will lead to the euro and the Australian dollar moving in the same direction synchronously. So there is a positive correlation between the euro and the Australian dollar.

How to benefit from currency correlation

Typically, correlation is used to confirm the correctness of the analysis. You can observe the behavior of a particular currency pair and, based on it, draw a conclusion regarding the currency pair correlating with it. The more trades move in the same direction, the higher the likelihood of establishing a new trend, which means that the chances of a successful trade also increase. This way you get additional confidence regarding simultaneous trades.

Correlation of currency pairs can double both your profit and your loss. Let’s consider an example of a positive correlation. For example, you risk 5% of your deposit and open trades in the positively correlating pairs EUR/USD and EUR/GPB. In this case, the total risk for these two trades will not be 5%, but rather 10%. However, the amount of profit will also double.

Forex currency correlation strategy

Trading with Forex correlation pairs is pretty straightforward. Depending on which currency pair you are trading, pay attention to other currency pairs whose quoted currency is the quoted currency of your financial instrument. You will need to carefully examine the price charts of currency pairs correlating with each other. If you clearly see that the price will fall in one of them, do not buy the currency correlating with this pair. Using this method, you can reliably filter out false signals.

Example No. 2

Let’s suppose your traded currency pair is the GBP/USD (British Pound and American Dollar). The US dollar is a special currency, as it affects the exchange rate of many world currencies. In this case, it would be reasonable to pay attention to the price chart of the EUR/USD pair (euro and US dollar) before making trading decisions. Also, do not forget about the news. Although you are trading in the pound, important data on the European currency can have a great effect on the British pound. This will be the true manifestation of currency correlation. Always pay attention to what happens with currencies that correlate with your trading instrument - this is the essence of trading with Forex correlation pairs.

Currency correlation indicator MT4

There are many currency correlation indicators for MT4 and MT5. For example, [OverLay Chart Correlation MT4][7] will help you determine if there is a correlation between currencies or other instruments. [Netsrac Correlation MT5 Trade Indicator]8 is also popular. Both can be downloaded free of charge from the official MetaTrader website. Links are attached.

HOWEVER there are no indicators and advisers in common platforms that can distribute roles between correlating pairs.

Trading uses non-linear approach, where the price flow is presented as a “measure of information”. In this case, when using entropy, we get indicators that allow one to understand which signals of the two assets are leading:

![LiteForex: Forex correlation pairs | How to trade using currency pairs correlation][9]

Forex quasi-arbitrage

The problem of quasi-arbitrage of currency pairs with the US dollar as the quoting currency is the lack of reliable signals about when to sell one and buy the other pair in order to capitalize on the discrepancy.

The figure shows two combined daily charts of the GBP/USD (above) and the AUD/USD (below):

![LiteForex: Forex correlation pairs | How to trade using currency pairs correlation][10]

There is a discrepancy between the trends of the pound and the Australian dollar, which began in the summer of 2013 and lasted about two years. Traders who entered the market when an inverse correlation between the pairs occurred could not calculate a deposit that could withstand the drawdown from such a difference in rates.

When calculating the profits and the deposit required to maintain the position, the feasibility of trades of this kind remains a big question.

Using the correlation between major currencies

Traders favoring the EUR/USD use carry-trade currencies to get leading signals. In the currencies of states with high-interest rates relative to Fed rates, trends begin earlier than they occur in the EUR/USD pair.

![LiteForex: Forex correlation pairs | How to trade using currency pairs correlation][11]

The combined charts of the AUD/USD and the EUR/USD show the areas where the EUR/USD is located on the lower Bollinger border with a period of 200, while the AUD/USD quotes cross the middle line of the indicator. It is easy to notice that after such discrepancies, the EUR/USD trend reverses trying to catch up with the AUD/USD trend that has moved ahead.

Conclusion: how to use forex correlation pairs

It is best to take correlation into account in 2 cases.

As a confirmation when opening a position:

With direct correlation, the chart of one instrument must not contradict the chart of the second one;
With an inverse correlation, we need the expected direction of further movement to be the opposite.

As a filter in calculating the total risk for all trades:

With a strong correlation, it makes no sense to open additional trades in the 2nd instrument if you already have open positions in the first one, because this will be equivalent to opening one trade-in double volume.

With a weak correlation, you can consider the 2nd instrument for opening positions in order to diversify trade.

Summing up, I should note that the correlation between financial instruments is not a constant factor. So it is recommended to use it not as an independent type of analysis when making decisions, but as a kind of filter.

FAQs

Which forex pairs are most correlated?

There are three most traded Forex pairs with a positive correlation: GBP/USD, AUD/USD, and EUR/USD. They are traded against the dollar (the dollar is the quote currency), and any change in the behavior of the dollar reflects in their rates. These currency pairs have negative correlation counterparts, which include USD/CHF, USD/JPY, and USD/CAD. They all have the dollar as the base currency, which is why they are moving in the opposite direction to the majors mentioned above. For example, for the AUD/USD pair, there are pairs with a positive correlation (NZD/USD, AUD/JPY, NZD/JPY) and negative correlation (USD/SGD, USD/CHF, USD/SEK).

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Ask me questions and comment below. I’ll be glad to answer your questions and give necessary explanations.

Useful links:

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![Forex pairs correlation and how to trade it][14]

The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteForex. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.

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