Currency Correlations - Part 2

[RichardCox 10]

Looking at the table in the previous article, we can see that while correlations do remain similar (for the most part), there are very clear changes that are reflective of macro economic influences and changes in sentiment. Correlations that exist today might not be in place over the longer-term, so pulling out to longer time frames will tend to give a more accurate picture of how each currency behaves in relation to its major counterparts.

 

Calculating correlations is actually a relatively simple process but these figures are posted in enough areas that making your own tables isn't totally necessary. So now that we know what these numbers are telling us, how can this information be used to structure trades and advantageously manage our total risk exposure?

 

Using Currency Correlations to Manage Risk

 

First, it should be understood that one of the most obvious mistakes that even experienced traders often make occurs when multiple positions are opened which have the total effect of canceling each other out. This can occur in instances where two currency pairs with historically high correlation levels are opened in opposing directions (for example, a buy is opened in the EUR/USD while a sell position has already been established in the GBP/USD).

 

While the argument can be made that there are acceptable reasons for doing this (such as evidence of a trend reversal or a newly visible entry zone that makes the new trading decision difficult to pass up), it has to be remembered that the overall effect of these opposing positions will be roughly neutral (removing the possibility for substantial gains). This will be more obvious when pairs that are commonly denominated (such as the EUR/USD and the GBP/USD) but the correlation tables can help us to identify important relationship in pairs that are not commonly denominated (such as in the EUR/USD and the GBP/JPY).

 

In other cases, errors can be made when similar positions are taken in highly correlated pairs (such as in the AUD/USD and the NZD/USD) are taken in the same direction (with both being buys or sells). There is the argument that taking the new position can be advantageous if the price levels are different (effectively improving your average price) but in essence, this is roughly similar to holding a double-size position in one of these pairs and in many cases this could violate your risk management plans.

 

Diversifying your Positions

 

Another way to advantageously use correlation tables is to view the readings as a means for diversifying your positions. Since pairs like the EUR/USD and the EUR/JPY have high correlation values, dual positions in these pairs can be used to express a certain market outlook (such as a risk averse market environment or a macroeconomic view relative to an individual country).

 

Keeping risk management planning in mind, positions can be scaled down and split into different pairs to avoid shocks or surprises relative to any single currency. Diversified positions can be opened when there is a potential event risk to be seen that will effect one of the currencies you have bought or sold. While the general direction of the correlated pairs is likely to continue to show agreement, the slight variation in the correlations in the diversified positions will reduce risk levels (albeit to a marginal degree).

 

Conclusion

 

For traders looking to balance risk, diversify positions, or to find new currency pairs to express a market view, correlation values can be an important element to consider before new trades are placed. Failing to understand how currency pairs behave in relation to each other can lead to unproductive (mostly neutral) positions or excessive risk exposure that could have otherwise been easily avoided. Given the drastic differences (or similarities) that some currency pairs posses, a proper understanding of these relationship must be present in order to effectively manage multiple trades.