How to trade with currency linkage? Very important!

What is currency correlation in forex?
A currency correlation in forex is a positive or negative relationship between two separate currency pairs. A positive correlation means that two currency pairs move in tandem, and a negative correlation means that they move in opposite directions.
Correlations can provide opportunities to realise a greater profit, or they can be used to hedge your forex positions and exposure to risk. If you can be certain that one currency pair will move alongside or against another, then you can either open another position to maximise your profits, or you could open another position to hedge your current exposure in case volatility increases in the market.
However, if your forecasts are wrong when trading currency correlations, or if the markets move in an unexpected way, you could incur a steeper loss, or your hedge could be less effective than anticipated.
The strength of a currency correlation depends on the time of day, and the current trading volumes in the markets for both currency pairs. For example, pairs which include the US dollar will often be more active during the US market hours of 12pm to 9pm (UK time), and pairs with the euro or the pound will be more active between 8am and 4pm (UK time) – when the European and British markets are open.


What are the risks of currency correlation?
There is a strong connection between currency correlation and risk management, and when you trade multiple currency pairs simultaneously in your trading account, it is important to make sure you understand your risk exposure. Maybe you think that you can spread your risk by trading multiple currency pairs, but you don’t know that many currency pairs tend to develop in the same direction, and you lose all.
For example, trading AUD/USD and NZD/USD is basically like opening two identical trades in most cases, as they usually have a positive correlation. By buying (or selling) both sets of currency pairs at the same time, you are actually exposing yourself to more risk without knowing it. When you buy 1 lot of AUD/USD and NZD/USD at the same time, it is equivalent to taking the risk of 2 lots of AUD/USD.
But when you buy two currency pairs with negative correlation at the same time, it does not mean that the risk can be offset to 0, because the spread of different currency pairs is different. In this case, there is a good chance that you are not only paying double the spread, but possibly minimizing your profit, or even losing money, because one pair eats away at the other.


How do we use currency correlation for transactions?
First, we must avoid transactions with strong negative correlation
When trading multiple currency pairs, we must avoid trading 2 currency pairs with strong negative correlation at the same time. Because these two currency pairs move in the opposite direction, if you open a position to go long or short these two currency pairs, one will gain and the other will lose;
If you are long and short, it is meaningless. The price changes of these two are one up and the other down. If you do it wrong, you will lose everything.
Second, use strong positive correlation transactions to increase leverage
Trading two currency pairs with strong positive correlation at the same time allows you to double your position and magnify your profits. For example, there is a strong positive correlation between the relationship between EUR/USD and GBP/USD, and the rise of EUR/USD is obvious. At this time, if you open a long position on each of the two currency pairs, it is actually equivalent to doubling the size of the EUR/USD position. But if you make a wrong judgment, you have to bear double the risk.
Third, we need to use positive correlation transactions to diversify risks
Note that the positive correlation here is not a strong positive correlation. Using currency correlation, you can spread your risk across two currency pairs that move in the same way, rather than trading a single currency pair all the time.
Fourth, confirm the transaction entry and exit signals
Using currency correlations, trade entry and exit signals can also be confirmed. For example, EUR/USD appears to be testing an important support level. You spot this price action and plan to go short on a breakout to the downside. Now that you know that EUR/USD is positively correlated with GBP/USD and negatively correlated with USD/CHF and USD/JPY, you can check that your judge.
If GBP/USD is trading around important support levels, while USD/CHF and USD/JPY are both trading at important resistance levels. This tells you that the recent move is relative to the US dollar, thus confirming the possibility of a breakout in EUR/USD as the other three pairs move in line with it, giving you the option to trade when the breakout occurs.
Assuming that the prices of the other three currency pairs do not move correspondingly to the correlation with EUR/USD, then this may be a false breakthrough and it is not appropriate to proceed rashly.

Posted on