__WHAT ARE CURRENCY CORRELATIONS__

__AND HOW DO__

__TRADERS USE THEM?__
When trading the FX market, one of the most important facts to
remember is that the price action of each currency pair is not
mutually exclusive. In many cases, foreign economic conditions,
interest rates, and price changes affect much more than just a single pairing. Everything is interrelated in the forex market to some extent, and
knowing the direction and how strong this relationship is can be used to
develop effective trading strategies and has the potential to be a great trading tool. The bottom line is that unless you only want to trade one currency
pair at a time, it is extremely important to take into account how different currency pairs move relative to one another. To do this, we can use
correlation analysis.

Correlations are calculations based on pricing data, and these numbers can help gauge the relationships that exist between different currency
pairs. The information that the numbers give us can be a good aid for any
traders who want to diversify their portfolios, double up on positions without investing in the same currency pair, or just get an idea of how much
risk their trades are opening them up to. If used correctly, this method has
the potential to maximize gains, gauge exposure, and help prevent counterproductive trading.

**POSITIVE/NEGATIVE CORRELATIONS: WHAT THEY MEAN AND HOW TO USE THEM**

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Knowing how closely correlated the currency pairs are in your portfolio is
a great way to measure your exposure and risk. You might think that you’re
diversifying your portfolio by investing in different pairs, but many of them
have a tendency to move in the same or opposite direction to one another.
The correlations between pairs can be strong or weak and last for weeks,
months, or even years. Basically, what a correlation number gives us is an
estimate of how closely pairs move together or how opposite their actions
are over a specified period of time. Any correlation calculation will be in
decimal form; the closer the number is to 1, the stronger the connection
between the two currencies. For example, by looking at the sample data we can see a +0.83 correlation between the USD/JPY and the
USD/CHF currency pairs over the past month. If you are not a fan of decimals, you can also think of the number as a percentage by multiplying it by
100 percent (in this case getting a 83 percent correlation between USD/JPY
and USD/CHF).

High decimals indicate currency pairs that closely mirror one another,
whereas lower numbers tell us that the pairs do not usually move in a parallel fashion. Therefore, because there is a high correlation between these
two currency pairs, we can see that by investing in both the USD/JPY and
the USD/CHF, we are effectively doubling up on a position. Likewise, it
might not be the best idea to go long one of the currency pairs and short
the other, because a rally in one has a high likelihood of also setting off a
rally in the other. While this would not make your profit and losses exactly
zero (because they have different pip values), the two do move in such a
similar fashion that taking opposing positions could take a bite out of profits or even cause losses.

Positive correlations aren’t the only way to measure similarities between pairings; negative correlations can be just as useful. In this case,
instead of a very positive number, we are looking for a highly negative one.
Just as on the positive side, the closer the number is to –1, the more
connected the two currencies movements are, this time in the opposite
direction. Let’s take a look at the EUR/USD, which has a very negative relationship with the USD/CHF. Between these two currency pairs, the correlation has been –0.83 over the past year and –0.94 over the past month.
This number indicates that these two pairings have a strong propensity to
move in opposite directions. Therefore, taking contrary positions on the
two pairs could be the same as taking the same position on two highly positive correlated pairs. In this case, going long in one and shorting the other
would be almost the same as doubling up on the position and as a result would also open your portfolio up to a higher amount of risk. However,
going long or short on both at the same time would probably be counterproductive and lead to near zero profit and losses, because the two currency pairs move in opposite directions. Therefore, if one side of the trade
became profitable, the other would usually result in losses.

**IMPORTANT FACT ABOUT CORRELATIONS: THEY CHANGE**

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Anyone who has ever traded the FX market knows that currencies are very
dynamic; economic conditions, both sentiment and pricing, change every
day. Because of this, the most important aspect to remember when analyzing currency correlations is that they can also easily change over time. The
strong correlations that are calculated today might not be the same this
time next month. Due to the constant reshaping of the forex environment,
it is imperative to keep current if you decide to use this method for trading. For example, over a one-month period that we observed, the correlation between AUD/USD and GBP/USD was 0.08. This is a very low number
and would indicate that the pairs do not really share any definitive trend in
their movements. However, if we look at the three-month data for the same
time period, the number increases to 0.24 and then to 0.41 for six months
and finally to 0.45 for a year. Therefore, for this particular example we can
see that there was a blatant recent breakdown in the relationship between
these two pairs. What was once a stronger positive association in the long
run has almost totally deteriorated over the short term. In contrast, the
EUR/USD and AUD/USD pairing has shown a strengthening trend in the
most recent data. The correlation between these two pairs started at –0.52
for the year and edged up to –0.63 for the past month.

An even more dramatic example of the extent to which these numbers can change can be found in the USD/JPY and AUD/USD pairing; there
was a +0.41 correlation between the two for the yearlong data. However,
while these two tended to move in reasonably similar directions in the long
term, over the month of April 2008 they were actually negatively correlated
with a –0.30 reading. The major events that change the degree and even direction that pairs are correlated are usually associated with the economic
developments and market sentiment at the time.

**CALCULATING CORRELATIONS YOURSELF**

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Because correlations have a tendency to shift over time, the best way to
keep current on the direction and strength of your pairings is to calculate them yourself. Although it might seem like a tricky concept, the actual process can be made quite easy. The simplest way to calculate the numbers
is to use Microsoft Excel. In Excel, you can take the currency pairs that
you want to derive a correlation from over a specific time period and just
use the correlation function. Taking the one-year, six-month, three-month,
and one-month trailing readings gives the most comprehensive view of the
similarities and differences between pairs; however, you can decide which
or how many of these readings you want to analyze. Breaking down the
process step-by-step, we’ll find the correlation between the USD/GBP and
the USD/CHF.

First you’ll need to get the pricing data for the two pairings. To keep
organized, label one column GBP and the other CHF and then put in the
weekly values of these currencies using the last price and pairing them
with the USD for whatever time period you want to use. At the bottom
of the two columns, go to an empty slot and type in =CORREL. Highlight
all of the data in one of the pricing columns, type in a comma, and then
do the same thing for the other currency; the number produced is your
correlation. Although it is not necessary to update your numbers every day,
updating them once every couple of weeks or at the very least once a month
is generally a good idea.

**SAMPLE CORRELATIONS RESULTS**

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