Currency correlation, as its name suggests, is the relationship between the currencies. If you observe charts, you may have noticed that as one currency pair increases, another one declines. Sometimes, the same currency pair will decrease, and another currency pair declines as if it seemingly copies the other one. If you are clueless about currency correlation and you already noticed this, you have already witnessed it just by looking at the charts.
Currency correlation defined
Financially, when we talk about correlation, it means the statistic gauge of two securities’ movement relative to each other. So, when we say currency correlation, we talk about two currency pairs and their movement— whether they move the same, different, or in unusual and random directions in a given time frame. Currency pairs are called as such because they never come as a single currency. Hence, not one currency is isolated. A trader should know the difference between every currency pair unless the plan is to trade only one currency pair because currency correlations can massively impact the trading account, especially when it comes to risk exposure. So, if you decide to trade multiple currency pairs, it’s your job to know as much as you can about risk exposure and currency correlations.
Next, we have a correlation coefficient.
How do we compute correlation? It is called a correlation coefficient with a range between -1 and +1.
- A perfect positive correlation, a correlation coefficient of +1, tells us that two currency pairs’ movements will be in the same direction throughout.
- A perfect negative correction, which is a correlation coefficient of -1, tells us that two currency pairs’ movements will be against the direction the whole time.
- A 0 (zero) correlation tells us that the two currency pairs do not correlate at all. Hence, they are independent. The movement of one pair will always be unpredictable concerning the other.
Overexposure and currency correlations
Knowing what risk exposure is and how it affects your trades is a big help in preserving your capital and being more profitable. For instance, NZD/ USD and AUD/ USD have a positive correlation. It means that they have almost the same, if not identical, movements. You might have different currency pairs but in reality, opening both NZD/ USD and AUD/ USD is like opening two NZD/ USD positions or two AUD/ USD positions. This is what we mean a while ago when we said that you should be aware of risk exposure because you would only be opening both NZD/ USD and AUD/ USD positions if you are not aware that they tend to move in the same direction. So, if you think you are delegating risks in different places, you are just doubling your risks. We can call this occurrence overexposure.
Capping it off
To end our day’s learnings, we repeat that currency pairs will never go isolated. Some are always together, and some go against each other. So, if you decide to trade multiple positions to delegate the risks, know more about risk exposure first. Also, correlation in pairs may be way too intense for a while, but it can actually change. So, stay tuned with currency correlations updates.