Volatility is something which could bring significant gains for a forex trader. However, it can also be the cause of large losses if investors are not careful. This is why understanding currency correlations is essential for any trader looking to make profits in the currency markets.
What Exactly is Correlation?
In the world of finance, correlation refers to the measurement of the statistical relationship between two securities. This is expressed through what is known as the correlation coefficient which can range from -1 to +1. A correlation coefficient of +1implies that the two specified currency pairs will in move in lockstep with one another 100% of the time. On the other hand, a zero correlation coefficient implies that there is a completely random relationship.
Interdependence of Currency Pairs
Currency correlations is one way to view how currency pairs can become interdependent. For example, if a speculator was trading the euro currency versus the Japanese yen (EUR/JPY), the market participant is essentially trading a derivative of two other currency pairs, the EUR/USD and USD/JPY.
Fluctuating Currency Correlations
However, correlations are not static and are constantly fluctuating. This is why traders should keep a close eye on correlation coefficients which can help speculators weigh the importance of correlations when making trading decisions.
Putting Currency Correlations to Use
Understanding currency correlations can help to avoid making two trades which essentially cancel each other out. It can also help to avoid doubling one’s risk unknowingly. On the other hand, correlations can also help a trader double his or her gains. Traders can also use correlations to diversify one’s portfolio and trading strategies. Those looking to hedge one’s trades can also utilize correlation data.
On the other hand, market correlation is just one aspect of a complete trading strategy. Many traders use various types of analysis in order to formulate trading decisions. Also, proper risk management is essential to maintain profitability over longer periods of time.
Le Bach Pham has been writing professionally after receiving his Bachelor’s of Art in English Literature from the University of California, San Diego in 2002. He now specializes in writing about legal, business and financial topics. Pham also earned a Paralegal Certificate from the University of San Diego and has experience working in the legal field. He also has experience in writing business plans for clients from various fields, including banking, finance, retail, education, beauty and various other sectors.