Understanding Pair Correlation

The value of a currency is measured by comparing it against the currency of another country. This is the reason behind the grouping of currency pairs that we know today. For example, the value of the Euro in the EUR/USD pair is determined by comparing that currency with the USD.

In general, we agree that if the price of a currency pair rises, we will make a purchase. This step is correct, but we have not yet considered the outlook for the next price movement. There is a possibility that the price will actually fall due to the influence of that pair’s correlation with other pairs.

• The correlation coefficient ranges from -1 to +1
  A correlation of +1 indicates that two currency pairs will always move in the same direction. A correlation of -1 indicates that a currency pair will consistently move in the opposite direction. A correlation of zero indicates that the relationship between currency pairs is completely random.
  
  
• Positive correlation
  A positive number but less than +1 indicates that two currency pairs generally move in the same direction but not always. A value close to +1 indicates that they mostly move in the same direction.
  
  
• Negative correlation
  A negative number but greater than -1 indicates that two currency pairs generally move in opposite directions, but this does not always happen. A value close to -1 means that they mostly move in opposite directions.

How can we use currency correlation when trading Forex? Ideally, correlation is dynamic and can change at any time. You can observe the correlation that has occurred in the last few days and compare it with the long-term correlation value, for example, over the past year.

If the short-term value is significantly different from the long-term value, it is likely that this is the time to open a trade. But how do we determine that?

For example, pairs A and B have a correlation value of 0.98 over the past year. This means that they have been moving almost in the same direction. When pair A moves up, pair B also moves at nearly the same pace.

Suddenly, you notice that over the last month or week, the correlation value of pairs A and B is 0.10. This means they are moving in the same direction but at very different speeds.

To clarify this condition, let’s imagine there are two cars moving in the same direction, one moving at 100 miles per hour and the other at 10 miles per hour. We might assume that the second one needs to catch up to the first at a higher speed. If so, what should we do? Let’s find out where the correlation lies.

When we use the car example to illustrate currency trading above, suppose a pair of currencies is moving in the same direction and has shown a correlation of 0.60 in the long term, and suddenly over the last few days it has dropped to 0.20. We just need to look at which currency pair’s movement is slower in its upward move, and that is the pair we will buy.