What is pair correlation and how to use it in trading? Let's consider simple examples of how pairs correlate with each other, how to calculate % correlations and apply it in trading.
The modern model of the world economy is global. Therefore, all its elements, including currency pairs, are interconnected.
The weakening or vice versa, the strengthening of the positions of large countries directly affects the financial markets, including the Forex market.
It is for this reason that it is very important to look for the relationship between various financial instruments in order to determine what is really happening.
Correlation is great for finding related currency pairs. In a mathematical sense, it denotes the strength of this connection:
- If the correlation coefficient is equal to 1, the relationship is direct, that is, price movements coincide.
- If it is equal to -1, the relationship is reverse, mirror.
In the Forex market, this dependence will show which currency pairs influence each other and which do not.
Relationships in the foreign exchange market
As you know, the US dollar supports most of the world economy. The same applies to the Forex market - the most active currency pairs are associated with the dollar.
Therefore, all dollar pairs (EUR/USD, GBP/USD, USD/CHF, etc.) correlate with each other to one degree or another.
The correlation coefficient of some pairs reaches 0.8-0.9, and in the case of the reverse pair USD/CHF - -0.8. A high value indicates a strong relationship.
There is also a relationship between some dollar pairs and the dollar index.
However, the correlation coefficient changes daily, so in some market conditions it can reach 1 or -1, while in others it tends to 0, which will mean a complete mismatch of movements.
It is not difficult to find these coefficients on the Internet. They can also be calculated using Microsoft Excel.
There are other dependencies in the Forex market
For example, gold and silver, which are usually present among financial instruments, often show high synchronicity of movements.
Not only dollar pairs can also correlate, but also cross-rates: the British pound or the Japanese yen, for example.
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How to use all this in trading?
The first thing to do is to mark all the coefficients for today on paper or in Excel.
Further, it all depends on your trading method. However, there are two proven methods that allow correlation to be successfully applied:
Confirmation of trading system signals. For example, the EUR/USD chart is overbought. The correlation of the euro with the pound - 0.85 - is a high value.
We look at the GBP/USD chart and see that there is also an overbought condition.
Conclusion - the signal is reliable, you can sell.
Risk diversification. The total lot you are trading can be divided into 2-3 parts and traded on 2-3 correlated charts.
If you apply the signal confirmation method, then their accuracy will be higher, and the risk will be less. In general, the profit should be higher than when trading on the chart alone.
Remember that the correlation coefficient changes. If it grows, this is a good signal, and if it decreases, some fundamental reasons move one pair, but do not move the other.
Therefore, constantly monitor changes in numbers.