Currency correlation in Forex trading is a technique that can significantly improve understanding of the market processes and the quality of trader's short-term and medium-term forecasts.
Correlation is a statistical term meaning the interrelated trends between two data series. In our case, the exchange-correlation is the correlation between historical data of one currency pair courses or changes the rate of one pair that could be related to the changes of the other pair. This relationship often has a fundamental economic rational meaning and rooted in features of the world economy. In simple terms, there are two currency pairs: A/B and C/D. If there is a correlation with growth rate A/B can be stably observed or the increase in the rate of C/D (it is a direct correlation) or its fall (then the correlation will be reversed).
Individual traders working on all platforms like currency, stocks, raw materials and others always notice a certain relationship between the various trading tools that they use. Moreover, the correlation is observed even between markets, that is why the traders in the Forex should have at least a small idea about the securities market and commodity market, especially, oil and gold. Changes in the dynamic and direction of movement on one market and one instrument often have a similar scale on the other and these general movements are called correlation.
In order, to assess the degree of mutual connection of various tools used such as the index of a correlation coefficient. Conventionally, this coefficient can range from -1 to +1:
- +1 indicates that two currency pairs are 100% correlated and synchronously moving in the same direction by the same distance;
- 0 indicates that the relationships between pairs do not exist;
- -1 indicates an inverse correlation and it means that the movement of one currency pair for any distance is duplicated by another couple but in the opposite direction.
Forex correlation indicator is dynamic and changes over time. A trader can apply it on the Forex market as an additional signal or trend indicator.
Types of correlation
There are two types of currency correlations that can help in trading:
A direct correlation of currency pairs is a phenomenon useful for improving the accuracy of predictions. Even trading in the same instrument, you can increase the prediction accuracy by applying the analysis of several currency pairs. Back to an example with A/B and C/D. Imagine that your trading instrument is A/B and you know that these currency pairs in direct correlation. So, it means that they go up and down synchronously. Your technical analysis has shown that the pair A/B should fall. Accordingly, if technical analysis of C/D says otherwise, there is a reason to doubt the reliability of the signal. If everything is correct you can be more confident to open a position. Knowing the relationship, it is possible to reduce the number of random signals. However, you should remember that correlation analysis works on a relatively large scale (on the hourly or half-hour charts). If your trading strategy is based on "minutes", these data can only prevent.
The point is that the relationship is manifested on the shift database timeline. It means that the change rate of a pair A/B is now the harbinger of change pair C/D in the future. If you collect a detailed information it will be enough for the trading strategies formation, the existence of such correlations can significantly improve accuracy. In fact, you have the tool of basic forecasting course.
Correlation is useful for market technical analysis as a trend indicator, it is especially important when you are trading several instruments. By using a mirror correlation can be hedged negative position, reducing risks and loss of deposit.
No matter what trading strategy is used by a trader in the Forex always recommended monitoring several correlated pairs, both direct and reverse correlation, in order not to miss an important signal to enter the market.