Defining Correlation in Finance
Correlation in finance is the statistical measure of the degree to which two securities are related to its other. This relationship is measured during a certain time period.
Correlation in finance is the statistical measure of the degree to which two securities are related to its other. This relationship is measured during a certain time period.
Correlations are expressed on a scale of -1.0 to +1.0, as follows:
- +1.0, two assets move in an identical direction, 100% of all times
- +0.0, two assets move in random directions
- -1.0, two assets move in the exact opposite direction, 100% of all times
The Dependency of Forex Pairs
No Forex pair is independent of the others. Correlations between pairs can be measured in various timeframes, but longer-term correlations (6-month or more) should be considered more reliable.
The knowledge of the basic correlations between Forex pairs is helpful because:
- Avoid high-risk exposure by not trading correlated Forex pairs at the same time
- Confirm any trading signal and avoid mistakes
- Optimize you Entry / Exit levels
- Determine easier the ‘sweet spot’ when opening trades
- Enrich the back-testing process of automated Forex strategies (by back-testing correlated pairs)
There are some groups of currencies that tend to trade on the same direction.
For example, this is a very strong group containing 4 pairs:
þ EURUSD, GBPUSD, AUDUSD and NZDUSD
Notes:
1. EURUSD and GBPUSD are correlated +0.8 to +0.9
2. Some traders add also EURJPY and GBPJPY on that particular group
3. This group in general trades the opposite direction than USDCHF, USDJPY and USDCAD
Chart::
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