In this lesson, we’ll take a closer look at the concept of currency correlation and how traders can incorporate it into their forex strategies. Recognizing and leveraging relationships between different assets can add depth to your market analysis and help you build more resilient trading plans.

What does correlation mean in forex?

Correlation describes how two instruments move in relation to each other. This relationship can be:

Positive Correlation

• Definition: Two assets are positively correlated if they typically move in the same direction.
• Example: The EUR/USD and GBP/USD pairs commonly rise and fall together. If the euro gains against the dollar, chances are the pound will, too.

Negative Correlation

• Definition: A negative correlation means that when one asset increases, the other tends to decrease.
• Example: Gold versus the US dollar (XAU/USD) often shows this relationship. As the US dollar appreciates, gold (quoted in dollars) usually gets more expensive for overseas buyers, which can dampen demand and push gold prices down. When the US dollar falls, gold can become more attractive, often resulting in higher prices.
• Another Illustration: A local stock index may rise when its domestic currency weakens. For example, in July 2024, the Japanese Nikkei 225 rallied even as the yen depreciated, reflecting an inverse connection.

Using correlation to design trading strategies

Currency correlations can be harnessed in two main ways:

1. Trade Confirmation

• When two highly correlated pairs are moving in unison, traders can use one as a signal or extra confirmation for trades in the other.
• Example: If EUR/USD and GBP/USD are both trending higher, this reinforces the strength of the move and could give you confidence to enter a buy position on either pair.

2. Risk Diversification

• Combining negatively correlated positions can spread out your risk, as losses in one position may be offset by gains in another.
• Example: If you diversify your portfolio to include trades in the Australian Dollar, Japanese Yen, and Chinese Yuan, you’re less vulnerable to shocks affecting any single currency, since each may respond differently to global economic shifts.

A caution about negative correlations

Using negative correlations can buffer risk, but they are not foolproof—no combination of assets can make you immune to losses. Be ready to adapt as correlations can shift with market conditions.

Summary

Understanding and applying correlation in forex lets you craft more comprehensive and flexible trading strategies. Practice identifying correlations and applying these tactics in a risk-free demo environment to develop both skill and confidence before moving to live trading.