Correlation in Forex Trading

Correlation in Forex Trading

When you trade the Forex, you must realize that you are, in fact, trading currency pairs as a single unit. These pairs comprise two currencies and its price is determined by dividing the value of one currency by that of the other. Forex correlation is the measured relationship between two units over a series of time. Correlation is measured on a range of -1 (perfect negative correlation) to 1 (perfect positive correlation). A positive correlation implies that the two units move in similar directions. In addition, the higher the correlation the closer and more accurately these movements are.

Conversely, a negative correlation represents opposite movements with a smaller (more negative) number representing a stronger relationship between the opposite movements.

You must appreciate that you are really making two trades when you back a currency pair in Forex trading. For example, if you trade the EUR/USD long, you are buying the EUR and selling the USD. As such, you must realize that you have activated a commercial relationship with two currencies. This is important to appreciate in order to understand the correlation and relationship of each of these two currencies, in question, to others.

Correlation in forex trading will help you determine if a trend of a currency pair is strong and if it will continue in the same direction. For example, the EUR/USD and the USD/YEN tend to move in opposite directions. If the EUR/USD is rising, the USD/YEN is falling. Consider that you have decided to go EUR/USD long because it has just broken an important resistance level. Before doing so, you should check the correlation of the USD/YEN to determine if it is just above a major support level. If it is, then you would be advised to stall your EUR/USD trade until you receive confirmation that the USD/YEN is capable of breaking its support.

There exists a strong correlation between the stock market and currency pairs as well. For instance, if the Dow Jones Index rises, then the higher yielding currencies such as the EUR, GBP and CHF tend to rise as well against the low yielding USD and YEN. The opposite is true if the Dow Jones falls.

By becoming aware and understanding the concepts about correlation will increase your chances considerably of achieving Forex success.

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