Currency correlations and how to use them when trading.
Some currency pairs are highly correlated while others may have little in common in terms of directional movement. Once you are mindful of these correlations and how they shift, you can apply this understanding to control your overall risk exposure. Currency correlation strategies are far more effective than typical indicator based systems in my opinion.
Strong correlations on one timeframe may not be in line with longer-term movements between two fx currency pairs. This is why taking a look at the longer term correlations can also be very important. Multiple timeframe analysis can be approached from many different angles and this is just one of them.
Correlations between fx pairs and the relative strength of each currency can also be a very useful filter when a trader is faced with multiple trading opportunities. Trading the hot hand i.e. the strongest versus weakest can be a very profitable approach if done correctly. In this post we will look into currency correlations and a real world example of how the data can be used.
The attached currency correlation charts show the relative strengths of each currency against the following (excluding the primary currency):
The coloured lines show the relative strength of each currency averaged out over the other listed pairs. This data can be utilised, as part of a calculated trading system, to play the strongest currencies versus the weakest.
The following currency correlation charts will be used as examples.
The Swiss Franc is currently the strongest, when referencing the daily time period currency correlation chart below, with the US Dollar the weakest currency.
At a simple level, trend traders may therefore be looking for USD/CHF short trade opportunities. Selling USD/CHF wisely could have been a very profitable strategy in recent times. There is of course a lag with this historical data but having the capability to identify the strongest and weakest pairs is invaluable when looking to apply any forex entry strategy.
Daily forex correlation chart shows falling Dollar and rising Swiss Franc
Weekly forex correlation chart shows strong Euro and weak US dollar.
We will now take a real world US dollar Japanese yen trade and cross reference the correlation charts above.
How do I use currency correlation information when trading? The old saying “loss of opportunity is better than loss of capital” is noteworthy in this respect.
US Dollar Japanese Yen example
USD/JPY gave a buy trade opportunity earlier this week when a bullish engulfing bar formed on the daily chart. Numerous traders will no doubt have entered, at market, on the closure of the daily candle or scaled in as price moved lower in anticipation of higher prices to come.
The daily forex correlation chart above clearly shows the Japanese Yen (purple line) has been at the higher end of the range all week while the US dollar has been falling deeper into new lows during the same period (white line). Lets now take a look at how the aforementioned long dollar trade would have worked out:
Anybody trading the candle with a stop loss beneath would have been stopped out…
However, if a filter was used specifying all trades had to be in alignment with present time correlations then this would never have been considered as an opportunity. If the trigger bar was in-line with the a more positive strength and weakness analysis scenario derived from a different currency correlation relationship between the dollar and yen then there may have been a better chance of the trade working out.
Other times that currency correlations can be of use.
- Trade entry confirmation and false breakouts of technical support and resistance areas. Look at other similar currencies/asset classes when planning to enter a trade and see if the market has confirmed your directional bias. This recent example involving Gold and Silver correlations at technical levels is a good example. Gold made a new low and Silver held above the support level. A sit and wait approach for anyone looking to short Gold would have been a good move in this particular scenario; the failure to break below support for Silver gave a less bearish precious metal scenario than Gold bears may have anticipated.
- To make sure you do not over expose yourself to correlated currency pairs. A long position on two dollar based currency pairs like GBP/USD and NZD/USD may leave you overly exposed to dollar strength scenarios. You could be basically entering the same trade using twice the position size, a dangerous scenario if things go against you.
There are many ways that currency market correlations can be used and this article has just touched on a few. I will update the blog with more real world examples as they present themselves over time.
If this has been of interest to you then you may also like the following posts:
Currency Correlation Strategy helps avoids a loss on GBP/USD Buliish Outside day.