Forex correlation refers to relationships that exist between several currency pairs. A good understanding of these relations can help you identify buying opportunities, minimize risks, and avoid mistakes when day trading. In this article, we will look at how to use correlations when day trading.
What are correlations in forex?
Currency pairs tend to have some relationships with each other. For example, in most cases, when the USD/TRY pair rises, there is usually a possibility that the GBP/TRY will fall too.
That’s because when the USD/TRY pair rises, it means that the Turkish lira has declined. When the lira declines against the dollar, there is usually a possibility that it will also drop against other currency majors like the euro or the dollar.
The chart below shows the relationship between the USD/TRY and GBP/TRY pairs.
USD/TRY vs. GBP/TRY
Therefore, having a good understanding of these relationships can help you substantially as a day trader. In the example above, you avoid shorting the two currencies at once. Doing so would expose you to more risks when the two currencies rise.
Types of forex correlations
Broadly, there are three main types of correlations. These types are based on how the relations are calculated. These types are Pearson, Kendal, and Spearman. The Pearson correlation model is the most commonly used.
A correlation calculation produces results that range from -1 to 1. As shown below, a result of 1 is usually a sign that the two currency pairs have a perfect correlation, meaning that they move in the same direction. A correlation coefficient of zero is a sign that there is no relationship between the two currency pairs. Finally, a correlation result of -1 shows that there is a perfect negative correlation.
Correlations results explained
The chart below has the GBP/TRY in the main chart. As shown in red, the pair has a correlation coefficient of almost 1 with the USD/TRY pair. Also, the currency pair’s correlation with TRY/GBP is -1.
How to calculate correlations in forex
The mathematical calculation of correlations is a relatively difficult process. Furthermore, the formula of the Pearson correlation is as complicated as shown below.
Pearson correlation example
However, in reality, the same calculation has been made easier by Microsoft Excel or Google Sheets which can automatically calculate the correlation between two currency pairs or other assets.
The first step to calculate the correlation is to find the raw data of the currencies. As you download it, ensure that you select the exact start and ending date. A simple mistake like that can lead to significantly different results.
After downloading the results of the two currency pairs, you should export this data into your spreadsheet and run the correlation coefficient. As mentioned above, if your result is close to 1, it means that the two currency pairs have a close relationship. If it is close to -1, it means that there is an exact opposite relationship.
Simple ways of finding correlations
In addition to this manual calculation, there are other strategies for finding correlations in the forex market. The most common one is to use your eyes. You can simply look at a chart and see whether the two currency pairs are related.
The second approach is to use the correlation coefficient tool in TradingView. In it, y0u simply enter the main currency you want to analyze and run the calculation using the coefficient tool. For example, in the chart below, we have done the relationship between the EUR/USD and GBP/USD pair. As shown, at the time of writing, the two currencies have a coefficient of 0.83. This means that they have a close, although not perfect relationship.
EUR/USD and GBP/USD correlation
When using TradingView, it is important to ensure that the data is from the same provider. That’s because the prices of similar currency pairs tend to differ across different providers. As shown below, the correlation coefficient of the same currency pair is different because of the brokers.
Importance of using the same provider
Another way of finding correlation is to use the free tools offered by companies like Investing.com, MyFxBook, and Oanda. These companies use technology to calculate currency correlations behind the scenes. The chart below shows the currency correlations of currency pairs on the weekly chart.
The chart above shows that the AUD/CHF and GBP/JPY have a correlation of about 95%. On the chart below, we see that the two pairs move in a similar direction on the weekly chart.
AUD/CHF and GBP/JPY correlation
How to trade with forex correlations
There are several approaches to using forex correlations in day trading. First, you can use correlations to hedge your risks. For example, in currencies with a close correlation, you can buy one and short another pair. If the two pairs rise, the first currency pair will be profitable while the second pair will make a loss. Therefore, your profit will be the first profit minus the loss. This is also known as a spread.
To use this strategy, you first need to do an analysis to determine the most probable direction that the currencies will move. This analysis should entail fundamental, technical, and price action strategies. You should then decide on the lot size of the two trades. If you believe that the price will rise, you should place a bigger buy trade of one currency and a smaller sell trade of the other pair.
The concept of correlation is widely used in the financial market. It is mostly applied when there are pairs trading or the so-called arbitrage strategy. When used well, correlation can help produce significantly positive results and hedge risks. To use it well, we recommend that you give it a try using a demo account.