Correlation in the Forex Market

Statistically speaking, correlation is the measured relationship between two units over a series of time. Correlation is measured on a range of -1 (perfect negative correlation) to 1 (perfect positive correlation). A positive correlation implies that the two units move in similar directions, the higher the correlation the closer and more accurately these moves are. Conversely, a negative correlation represents opposite movements with a smaller (more negative) number representing a stronger relationship between the opposite movements.

It is important to understand that in the forex market you are trading currency pairs as a single unit. These pairs consist of two different currencies and are priced based on the value of one currency divided by the other. Technically you are making two trades when you trade any forex pair. You are buying one currency while simultaneously selling the other. For example: with the AUD/USD you are buying the AUD while selling the USD when you go long the pair. So, instead of looking at currency pairs as a single unit like a stock or a commodity, it is more appropriate to look at currency pairs as two separate trades. Viewing forex pairs as two separate trades will help you understand the relationship between other currency pairs, and will help to clarify why there seems to be an outstanding amount of correlation within the forex market.

Creating Healthy (Forex) Relationships

If you were to compare some of the major pairs in the forex market, you would immediately notice that many have an uncanny resemblance in their pattern. Below is an example of the EUR/JPY vs. EUR/USD:

The above two pairs move in such a similar manner and show a high level of correlation. There is a simple reason for this and becomes apparent when you break the trades down. In both the EUR/JPY and EUR/USD you are buying the EUR and selling some other currency in a long trade. If you take another look at what you are actually comparing in mathematical form the reason for the strong correlation becomes quite obvious:

Now take the example of the USD/JPY and EUR/USD:

In this example you see a highly negative correlation. Similarly to the last example, the driving factor here is the increased appearance of a specific currency. In this case the USD. However the difference in this case is that you have the currency appearing on opposites ends for each trade. Because one pair is buying and one is selling, you have inadvertently caused a negative relationship. To further illustrate this point, let's assume that the only currency that moves is USD, while the two other currencies (JPY and EUR) remain flat. Now you are effectively comparing the relationship of USD to that of the inverted USD, which is rather useless. Here is the comparison in equation form:

Understanding Correlation in the Forex Market

When comparing pairs in the forex market for correlation, it is usually not wise to have a currency represented more than once. In the comparison of two currency pairs you will have a total of four currencies affecting the relationship. To avoid one currency from being overstated it is vital that all four currencies, regardless of whether they are being bought or sold, only appears once. By doing this you can create unique relationship that will be able to give you a valuable and unique insight in to the relationship of two pairs. Correlation comparison can potentially set you up for new and exciting trading opportunities as well as offer you several unique trading strategies. In order for you to understand and realize these opportunities you must first understand the full breadth of what is being compared.

Matthew Cherry
TradersChoiceFX - Forex Broker

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