Understanding correlations also helps in diversifying and hedging out a portfolio. Diversification has for long been identified as a key way of minimizing losses. That is the main reason why successful traders such as George Soros and David Einhorn have taken positions in many companies. By using correlation, it will help you identify the best positions to go long, short or both.
Hedging also helps to minimize losses. A trader using the correlation strategy needs to understand a number of things. One, he needs to understand the procedure of calculating correlation. Secondly, the trader needs to understand how to interpret the results from the correlation. Finally, the trader needs to understand how to incorporate correlations in his trading strategy because this data will not always be adequate to determine a sell, buy, or hold position.
Related Ideas
Calculating the correlation between currency pairs might seem difficult. However, doing this is not as difficult as it seems.
All you need to do this is Microsoft Excel and historical data. Historical data is available for free in most charting platforms.
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Many data vendors also provide the data for a fee. Once you have calculated the data, you need to download it and export it to Excel. The best data to use to calculate correlation is a combination of 1 year, 3 month, and one month data. You can also narrow it down to weeks and days. Since the correlation data changes, you should update it on a regular basis. Another strategy to get the correlation data is by the use of websites and brokers who provide the information for free.
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In Google, just search for currency correlations and you will find the information. Having the correlated data is not enough. Interpreting it is the most important aspect in trading. The table below will help you a great deal in interpreting the data. In the table above, you can see three main areas: Perfect positive correlation, perfect negative correlation, and no correlation.
In perfect correlation, the two currency pairs are most likely to move in the same direction.
HOW CURRENCY CORRELATION HELPS YOU TRADE PROFITABLY
When the correlation is a perfect negative, the two currency pairs will move in different directions. If the correlation is 0, then no correlation exists. The following table is an example of an automated correlation table. From the above table, a number of things are evident. One, the correlation figures are never the same. In the AUDCAD pair, the 1 hour correlation figure shows a negative correlation while the daily, 1 week, and 1 month pairs are positive correlations. In addition, it is evident that a perfect correlation of 1 is never possible.
Therefore, it is very important to understand how currency pairs move in relation to one another. This will help you understand the exposure of each trade that you enter. Understanding price relationships between various currency pairs allows you to get a more in-depth look at how to develop high-probability Forex trading strategies. Awareness of currency correlation can help to reduce risk, improve hedging, and diversify trading instruments.
In this article, we will introduce you to Forex trading using intermarket correlations.
Correlation is a statistical measure of the relationship between two trading assets. Currency correlation shows the extent to which two currency pairs have moved in the same, opposite, or completely random directions within a particular period. Analysis of two asset relationships using past statistical data has predictive value. By utilising the correlation coefficient, we can understand the relationship between two values and help manage risk. Naturally, the stronger a positive or negative correlation, the higher a predictive value is drawn from the analysis. More extended time frames used for a technical analysis display more precise information compared to relationships over one minute, which have a little value.
Monthly and yearly data generally provide the most reliable insight. Correlation can be even a more powerful Forex tool for analysis in conjunction with other Forex indicators. For instance, if one pair breaks out above or below a significant technical level of support or resistance, the closely positively correlated pair has a high probability of the following risk.
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If you notice two negatively correlated currency pairs and a significant upward price reversal in one pair takes place, then you can anticipate a potential downward reversal in the other pair. This is a price reversal. Wait for an abnormal divergence between two highly correlated currency pairs and buy one and sell the other, with the expectation that they will converge in price movement again.
This is a non-directional arbitrage exploiting currency correlations.
Correlation-Based Forex Trading Strategies
The Canadian dollar and crude oil have a positive correlation because Canada is a significant oil producer and exporter. Similarly, the Australian dollar and gold have a positive correlation because Australia is a significant gold producer and exporter. Both gold and the Japanese Yen are viewed as safe havens in times of uncertainty, and these two are also positively correlated.
When the U.