Suppose you have the data and calculated the currency correlations of the major pairs. The correlation between GBP/USD and EUR/USD is 0.68. This correlation coefficient means both the pairs move in the same direction 68% of the time.
USD/CHF and EUR/USD have a correlation coefficient of -0.975 and is pretty close to (-1). It means both USD/CHF and EUR/USD pairs move in the opposite direction almost 97.5% of the time. It means if USD/CHF moves up, the pair EUR/USD will move down!
You have this information that tells you how much these pairs move in the same or opposite directions. You trade the pairs USD/CHF and EUR/USD at the same time by going long on both. You are in fact canceling both the positions.
If you win on USD/CHF pair, you will lose on EUR/USD pair. Due to the negative correlation between the two pairs, the two trades would effectively cancel each other. A savvy investor would go long on USD/CHF. At the same time he/she will go short on EUR/USD. So he/she will be shorting USD in both the trades and diversifying the USD bearish investment.
You can make trade entry and exit decisions based on currency correlations. Suppose GBP/USD starts showing volatility and approaches a resistance level. You anticipate going long on a breakout.
However, you notice on the charts that the other three major currency pairs are not showing volatility and moving as much as the GBP/USD. EUR/USD is not showing volatility and moving up on the chart. USD/CHF is not showing much volatility and moving down on the chart. USD/JPY is also not showing much volatility and not moving down on the chart. This means that the volatility in GBP/USD is solely GBP driven. The move is maybe related to some news in the British economy about Bank of England raising or lowering interest rates or some big companies merging.
Now you know that the move in GBP/USD pair is Pound driven and not US Dollar driven. You can take advantage of this information by ignoring the GBP driven move and waiting for a later opportunity that involves simultaneous correlated moves of all the major pairs.
Take another example. Suppose you have entered a short EUR/USD trade. You want to know whether the pair will either proceed down towards your profit target or go against you and cause you to exit the trade with a small loss.
Your EUR/USD has broken the S1 support pivot level. It is heading towards M1. Take a look at the pair EUR/GBP. You find that it has paused at its S1 support pivot level and is showing signs of reversing to the upside.
Knowledge of currency correlations can tell you if EUR/GBP breaks through the S1 level, you are poised for a profitable trade in this type of a situation, However, you should watch the indicators and exit before taking a big loss if it reverses and heads back to the upside. You might consider trading a basket of all the major currencies as you mature in forex trading. - 23309
USD/CHF and EUR/USD have a correlation coefficient of -0.975 and is pretty close to (-1). It means both USD/CHF and EUR/USD pairs move in the opposite direction almost 97.5% of the time. It means if USD/CHF moves up, the pair EUR/USD will move down!
You have this information that tells you how much these pairs move in the same or opposite directions. You trade the pairs USD/CHF and EUR/USD at the same time by going long on both. You are in fact canceling both the positions.
If you win on USD/CHF pair, you will lose on EUR/USD pair. Due to the negative correlation between the two pairs, the two trades would effectively cancel each other. A savvy investor would go long on USD/CHF. At the same time he/she will go short on EUR/USD. So he/she will be shorting USD in both the trades and diversifying the USD bearish investment.
You can make trade entry and exit decisions based on currency correlations. Suppose GBP/USD starts showing volatility and approaches a resistance level. You anticipate going long on a breakout.
However, you notice on the charts that the other three major currency pairs are not showing volatility and moving as much as the GBP/USD. EUR/USD is not showing volatility and moving up on the chart. USD/CHF is not showing much volatility and moving down on the chart. USD/JPY is also not showing much volatility and not moving down on the chart. This means that the volatility in GBP/USD is solely GBP driven. The move is maybe related to some news in the British economy about Bank of England raising or lowering interest rates or some big companies merging.
Now you know that the move in GBP/USD pair is Pound driven and not US Dollar driven. You can take advantage of this information by ignoring the GBP driven move and waiting for a later opportunity that involves simultaneous correlated moves of all the major pairs.
Take another example. Suppose you have entered a short EUR/USD trade. You want to know whether the pair will either proceed down towards your profit target or go against you and cause you to exit the trade with a small loss.
Your EUR/USD has broken the S1 support pivot level. It is heading towards M1. Take a look at the pair EUR/GBP. You find that it has paused at its S1 support pivot level and is showing signs of reversing to the upside.
Knowledge of currency correlations can tell you if EUR/GBP breaks through the S1 level, you are poised for a profitable trade in this type of a situation, However, you should watch the indicators and exit before taking a big loss if it reverses and heads back to the upside. You might consider trading a basket of all the major currencies as you mature in forex trading. - 23309
About the Author:
Mr. Ahmad Hassam is a Harvard University Graduate. He is interested in day trading stocks and currencies. Know These Forex Broker Games. Learn Forex Trading!
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