Complete Guide to Currency Pair Correlation
The Forex market involves trading currencies in order to profit from their moves. This is the biggest and most liquid market in the world and currencies are being grouped in currency pairs that a trader can buy or sell. Having said that, it means that a trader is actually buying or selling a currency pair and not a currency per se, even though, when traders are referring to the positions they have or they want to open, they are saying that they bought Euro, or the U.S. dollar, etc., when in reality they bought the Euro against another currency. Such a distinction is crucial as, for example, the Euro as a currency may trade mix on any given day, with EUR/USD and EUR/JPY moving to the downside and EUR/GBP moving to the upside. In the three currency pairs mentioned above, the Euro was bearish when compared with the U.S. dollar and the Japanese Yen, and bullish when compared with the Great Britain Pound. Therefore, the Euro as a whole was mixed on that trading day. Exactly the same thing described above, which is valid for any given currency, applies to currency pairs. However, on top of that, currency pair trade based on different correlations degrees with one another and with other financial markets as well. As mentioned in another article here on our Forex Trading Academy, currency pairs are grouped in majors and crosses, this being their main classification. Trading a major pair is completely different than trading a cross pair and knowing that allows a trader to correctly position from both a strategy point of view as well as from having the correct profit expectations.
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Trading Correlated Markets
Currency pairs are often referred to as being different markets and there are various correlations one should take into account. These correlations consider both currency pairs as well as other financial products, and below there are the main correlated categories as well as tips and tricks on how to trade them and what to consider in order to make a profit.
Two Majors and One Cross
Because the currency market is organized around the U.S. dollar, the currency pairs that have the U.S. dollar in their componence are called majors and any other currency pair is a cross. As mentioned above, trading majors and crosses is a totally different thing, and on top of that, one should consider the fact that for any major pair, there is a cross that is influencing the way it is moving. In order to illustrate that, let’s look at an example, and for this we’re going to refer to the EUR/USD and GBP/USD (therefore, two major pairs) and the corresponding cross, EUR/GBP. To find out what is the corresponding cross of these two major pairs, all we have to do is to simply cut the USD dollar out of the equation and the result is the EUR/GBP currency pair. Economic events that influence these three currency pairs are coming from the United States, Eurozone, and the United Kingdom. Any economic news on its own can influence minimum two currency pairs out of these three. However, there’s a way to trade them in a correlated fashion, and this is when the U.S. dollar is moving or when a U.S. dollar driven event is about to hit the wires. On any U.S. dollar move, the EUR/USD and GBP/USD majors will move in the same direction. If the percentage is the same, then the EUR/GBP cross will stay very much flat or move little. In other words, before an important economic event out of the United States, the way to trade is to invest in crosses and let the major pairs doing their thing until the news passes. This way, one is avoiding the volatility surrounding the U.S. dollar event, so manages that risk, and trades a currency pair that is not supposed to move that much, but it is supposed to respect ranges. Trading with the help of an oscillator in order to find out overbought and oversold levels should do the trick for safe returns.
JPY Pairs and the U.S. Equity Markets
There is a direct correlation degree between the JPY pairs and the U.S. equity markets, namely the Dow Jones and S&P500 indices. At some moments in time, this correlation was so strong that for every two points the Dow Jones moved, the USD/JPY moved one pip as well. These days this correlation is not that strong but certainly it is there especially when there are no economic releases to influence trading. Traders know that this is a very difficult correlation to trade as one is facing a tough choice when a U.S dollar event is coming: if the event is bullish for the dollar, one should buy the USD/JPY and sell the equity indices on the back that the Federal Reserve of the United States will come and hike the rates. Higher rates are negative for stocks but bullish for the currency, and the logic above makes sense. However, this logic is often broken by the direct correlation mentioned earlier, so trading these two markets on a U.S. dollar driven event is fairly tricky.
USD/CAD and the Oil Market
The Canadian economy is highly dependent on what is happening in the oil market as a vast proportion of its Gross Domestic Product (GDP) is related to the oil industry. Changes in oil prices, production levels and disruptions of the overall supply and demand channel are heavily influencing the Canadian dollar, therefore the USD/CAD pair, which is the major that represents the Canadian dollar the most. Any positive news for oil should be met with a higher Canadian Dollar, so a lower USD/CAD move should follow, while an oil negative news should result in higher USD/CAD levels to follow. These are just a few correlations examples between currency pairs or between currency pairs and other markets and they are pretty much valid these days as they were valid a few years ago as well. There are many other things to consider, like risk-on and risk-off environments, but these disappeared lately due to the fact that interest rates in major economies are very different.
Understanding these correlations and taking them in consideration before opening a trade on the Forex market is critical for any account. Moreover, it is making the difference between being a successful trader or not.
Other educational materials
- Popular Forex Currency Pairs
- Three Ways to Trade Forex with CCI (Commodity Channel Index)
- Overbought and Oversold Areas in Ranging Markets
- Profit from DeMarker Divergences
- Majors and Crosses – How to Trade Them?
- Leverage and Margin Requirements
- Forex Trading Platforms – Metatrader 4 and 5
Recommended further readings
- “Correlation networks among currencies.” Mizuno, Takayuki, Hideki Takayasu, and Misako Takayasu. Physica A: Statistical Mechanics and its Applications 364 (2006): 336-342.
- “Stochastic skew in currency options.” Carr, Peter, and Liuren Wu. Journal of Financial Economics 86, no. 1 (2007): 213-247.