Correlation is the ability of one trading asset to repeat the directed movements of another one.

On the financial markets, this phenomenon can be visually identified in pairs with gold and silver, as well as various types of oil and oil products.

The strength of the correlation is measured in percent (or fractions): 100% (or one) is the highest degree of correlation between two assets. To determine this value, traders use Pearson's formula: select a set of price values ​​for the two assets X and Y, determine the average values ​​of X and Y within this set, add the result of deviation of each set value from its average and divide them by the result of the standard deviation.

For two instruments with prices X and Y, the correlation coefficient formula will be as follows:

 

Correlation of Currency Pairs and How to Use It Properly

On the Forex market, the interrelation of trading assets was determined at the stage of its emergence, when instead of using the "gold standard", the national currency rates were tied to the US dollar.

It is believed that the major currency pairs have a greater degree of correlation between them than the minor pairs:

 

Correlation of Currency Pairs and How to Use It Properly

You can find many online services that calculate the correlation of Forex market instruments. However, there are practically no trading tactics based on correlation.

The interrelation of currencies via the US dollar can be used in two types of strategies:

  • Having determined two correlating currency pairs, you use one of them to track signals that can indicate the direction of future movement of the second pair.
  • Using discrepancies (inverse correlation), traders simultaneously sell one pair and buy another, or use cross-currency exchange ratios. In this case, the deviation of the two assets becomes the profit of the trader when the correlation restores and their movement coincides again.

 

Leader and follower

There are no indicators or advisers in major platforms that can distribute roles between correlating pairs.

In trading, a non-linear approach is used, where the price flow is presented as a "measure of information". In this case, with the use of entropy, we get indicators that let us understand which signals of the two assets are leading:

 

Correlation of Currency Pairs and How to Use It Properly

 

Quasi-arbitrage on Forex

The problem of quasi-arbitrage of currency pairs with the US dollar as a quotation currency is the lack of reliable signals to sell one and buy another pair in order to make profit on the discrepancy.

In the figure, two combined daily charts of GBP / USD (above) and AUD / USD (below) are presented:

 

Correlation of Currency Pairs and How to Use It Properly

There is a discrepancy between the trends of the pound sterling and the Australian dollar, which began in the summer of 2013 and lasted about two years. Traders who entered the market upon the emergence of inverse correlation between pairs could not calculate a deposit capable of sustaining a drawdown from such a divergence of rates.

When calculating the profit received and the deposit required to maintain the position, the expediency of trades of this kind remains a big question.

 

Using the correlation between major currencies

Traders working with EUR/USD pair use carry-trade currencies to obtain advanced signals. In the case of currencies of states with high interest rates as compared to the rates of the Fed, trends start earlier than they occur with EUR/USD pair.

 

Correlation of Currency Pairs and How to Use It Properly

The figure shows the combined AUD/USD and EUR/USD charts and the areas where EUR/USD is at the lower Bollinger limit with a period of 200, while AUD/USD crosses the middle line of the indicator. It is easy to see that after such discrepancies, the EUR/USD trend reverses trying to catch up with the leading AUD/USD trend.


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Correlation of Currency Pairs and How to Use It Properly

The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteForex. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.

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