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Understanding Currency Correlation in Forex Trading
Markets are interlined. You will find that many currency pairs show correlations. What this means is that they move together. This movement can be in the same direction or in the opposite direction. When you trade two currency pairs that move in the same direction, you are infact increasing your risk by going long or short on both of them at the same time.
You might be thinking that you are diversifying your portfolio by trading different currency pairs but you might never know that most of the currency pairs are moving in the same direction. This movement of the currency pairs in the same direction will increase your level of risk. Now, these correlations between the different currency pairs can continue for weeks, months or even years.
Let’s take an example. USDJPY and USDCHF may be showing a high positive correlation in the last month. This high positive correlation something like +0.86 means both are moving in the same direction.
When you trade both these pairs together, you might double your risk unintentionally. In the same manner, it might also not be a good idea to good long on one and short on another because rally in one pair will most likely set a rally in the other pair as well.
Now, two currency pairs might show negative correlation as well. For example EURUSD and USDCHF might be showing high negative correlation for the past few months. Suppose, it it -0.84. What this means is that both are moving in the exact opposite direction most of the time.
So, going long on one and short on another will only double your position. In the same manner, going long or short on both at the same time will also be not good as it might end up with zero profit or almost zero profit.
The important thing for you to understand is that these correlation coefficients keep on changing with time. So, if two pairs are showing a strong correlation, they might not show such a strong correlations a few months down the road.
This is due to the fact that the market conditions keep on changing plus market sentiment also changes over time. So, these correlation coefficients between different currency pairs are not going to be the same every month.
As a rule, when you trade more than one currency pairs, you should keep these correlations in your mind. This way, you will not be unintentionally increasing your risk when trading with different currency pairs.
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