Currency Correlations - Part 1

[RichardCox 10]

One of the things that separates the forex markets from those where other asset types are traded is the fact that currencies are priced in pairs. Essentially, what this means is that we are never buying or selling a currency by itself. Instead, currency performance can only be viewed in relative terms and this can have drastic on the type of trades that should be placed and the various strategies that should be implemented.

 

If this didn't complicate things enough on its own, another factor that traders must understand is that some currencies are highly correlated with some of its counterparts and inversely correlated with others. But while it might seem to be a daunting task to research and memorize the ways various currencies align with each other, currency correlations can provide traders with potential trading opportunities and tactics for managing your total risk exposure at any given moment.

 

Understanding Correlation

 

Comprehending the interdependence that is seen in currency pairs is easier in some cases than it is in others. For example, when dealing with the EUR/JPY we would expect there to be some similarities to others, such as the EUR/USD and the USD/JPY. A trading session particularly strong buying activity in the Euro would likely send the EUR/JPY higher but if the same trading period saw the EUR/USD trading lower, we would know that the US Dollar was the strongest of the three currencies that session, with an inevitable run higher in the USD/JPY.

 

More specifically, correlation can be measured using the “correlation coefficient”, which ranges from +1 (highly correlated) to 0 (unrelated or random) to -1 (inversely correlated). Currencies with a coefficient of +1 would essentially move in lock-step with each other. Currencies with a coefficient of 0 would have no decipherable relationship with each other. Currencies with a coefficient of -1 would show price patterns that are mirror images of each other. Of course, most currencies will not fall exactly into one of these categories and instead will fall into some interval degree of these three coefficients.

 

Correlation Tables

 

Many currency brokers offer currency tables that display the correlation coefficients of the most commonly traded pairs. These are updated regularly, so traders will always have the most up to date information. Below is the currency table that is offered by OANDA, separated by regular time intervals:

 

 

The table above shows the relationships between the EUR/USD forex pair and its commonly-traded counterparts (along with silver and gold). Relative to the EUR/USD, the EUR/JPY has a 1-week correlation coefficient of 0.81, while the USD/JPY has a 1-week correlation coefficient of 0.57. To better understand these coefficients, the following descriptions are given:

 

• 0.0 to 0.2 Very weak to negligible correlation
  
• 0.2 to 0.4 Weak, low correlation (not significant)
  
• 0.4 to 0.7 Moderate correlation
  
• 0.7 to 0.9 Strong, high correlation
  
• 0.9 to 1.0 Very strong correlation
  

 

From this, we can see that the 1-week correlation between the EUR/USD and the EUR/JPY is “strong,” while the 1-week correlation between the EUR/USD and the USD/JPY is “moderate.” The EUR/USD and the EUR/JPY will move in the same direction 81%, while the EUR/USD and the USD/JPY will move in the same direction 57% of the time.

 

These numbers, of course, are constantly changing depending on the various market conditions currently in place. In this case, the longer term 1-year correlation became stronger in the EUR/USD – EUR/JPY, while it weakened in the EUR/USD – USD JPY. Interestingly, looking at the table above, the EUR/USD and the USD/CHF had a perfect negative correlation of -1 during the latest 1-week to 3-month periods. With this, we can see that these pairs moved in opposing directions 100% of the time. In the next article, we will look at ways this information can be used to construct trading plans.

[svb70 10]

Great stuff! Nice technical post explaining correlation. I recently blogged about correlation and I think it may compliment your post. forex - an interesting look at correlation - barrett's notes

[BlueHorseshoe 10]

"One of the things that separates the forex markets from those where other asset types are traded is the fact that currencies are priced in pairs. Essentially, what this means is that we are never buying or selling a currency by itself."

 

Surely this is true for all instruments - a commodity futures contract, for example, is priced against a currency (usually dollars)?

 

Whether money is exchanged for derivatives, a concrete commodity, or other money, this relationship still exists.

 

BlueHorseshoe

[Obsidian 10]

This correlation subject is a bit tricky imo...when it comes to determine which one is driving the other one...

[RichardCox 10]

"One of the things that separates the forex markets from those where other asset types are traded is the fact that currencies are priced in pairs. Essentially, what this means is that we are never buying or selling a currency by itself."

 

Surely this is true for all instruments - a commodity futures contract, for example, is priced against a currency (usually dollars)?

 

Whether money is exchanged for derivatives, a concrete commodity, or other money, this relationship still exists.

 

BlueHorseshoe

 

 

If you want to simply argue for the sake of arguing, sure, everything is priced against something. If I buy a buy a playstation I am trading against the value of the xbox (or carrots, or whatever else) because I don't own those other things.

[wrbtrader 10]

This correlation subject is a bit tricky imo...when it comes to determine which one is driving the other one...

 

Currency correlations can be exploited in other ways regardless to whom is leading whom. Yet, if someone has a a strategy based upon whom is leading whom...I agree that such is tricky in my experience.