If you’re a forex trader, then you know that correlations are important to consider when making trading decisions. In this blog post, we will discuss five reasons why you should use currency correlations in your trading.
Using Currency Correlations to Diversify Risk
Another major benefit of using currency correlations is that it allows you to diversify risk. By understanding how two or more currency pairs move in relation to each other, you can enter trades that are protected against one another. This will help reduce the overall risk of a portfolio and can increase profits as well. For example, let’s say you’re bearish on the U.S. dollar. You could go short on AUDUSD, you could also go short on NZDUSD and shield yourself from a little bit of risk and diversify your overall position.
Hedge Some of Your Risk
Currency correlations can also be used to hedge risk. You may realize smaller profits but also minimize losses. By understanding how two currencies move relative to each other, you can enter trades that hedge your risk in a certain market. This will help protect you against any sudden changes in the price action of either pair. An example would be to go short in EURUSD and then also go short in USDCHF to hedge the risk. Since they are negatively correlated, a loss in one of those positions is offset by a gain in the other.
Less Counterproductive Trading
As we mentioned in the previous post, doubling your risk on correlated pairs can lead to counterproductive trading. Currency correlations can help you eliminate counterproductive trading by alerting you when two currencies are moving in the same direction. By understanding how these relationships work, you can avoid taking on trades that will cancel each other out, while still allowing you to capitalize on opportunities that arise from strong correlations.
Currency correlations can also be used to help you leverage profits. If you decide to trade two pairs with a correlation, you can increase profits, but also increase losses — so beware. By placing a long trade on GBPUSD and EURUSD, you stand to make more profit if they continue moving in an upward direction.
Currency Correlations to Confirm Breakouts and Prevent Fakeouts
Finally, currency correlations are also useful for confirming breakouts and avoiding fakeouts. You know, for example, that EURUSD is positively correlated with GBPUSD and negatively correlated with USDCHF. If EURUSD is trading near a significant support level, you can check the other two pairs for confirmation. If GBPUSD is also trading near a significant support level and USDCHF is at a resistance level, you know the recent move is dollar-related and can trade a breakout accordingly.
If, however, the GBPUSD is holding and USDCHF is moving sideways, you can take that as a signal that the EURUSD move is euro-related and not dollar-related and trade accordingly.
By understanding and using currency correlations, forex traders can eliminate counterproductive trading, leverage profits, diversify risk, hedge risk and confirm breakouts and avoid fakeouts. This knowledge can give you an edge in the market, helping you make more profitable trades. If you’re looking to become a successful forex trader, then understanding how currency correlations work is a must.
Disclaimer: All information provided here is intended solely for study purposes related to trading financial markets and does not serve in any way as a specific investment recommendation, business recommendation, investment opportunity, analysis, or similar general recommendation regarding the trading of investment instruments. The content, in its entirety or parts, is the sole opinion of SurgeTrader and is intended for educational purposes only. The historical results and/or track record does not imply that the same progress is replicable and does not guarantee profits or future profitable trading records or any promises whatsoever. Trading in financial markets is a high-risk activity and it is advised not to risk more than one can afford to lose.