Have you ever placed the same trade on two different instruments, only to see your losses double when both trades move against you? If so, then you know firsthand how painful it can be to make this mistake.

What many traders don’t realize is that if two instruments — like currency pairs in the forex world — are highly correlated, then placing trades on both of them effectively doubles your risk exposure. So, if you’re thinking about adding another instrument to your portfolio, make sure that it’s not too closely linked to the ones you’re already trading. Otherwise, you could end up taking some unnecessary losses.

Don’t Double your Risk Exposure by Placing the Same Trade on Two Correlated Instruments

Traders should be mindful of the risks they take when trading in the markets. Correlations exist across many instruments. The S&P 500 and the Dow Jones are positively correlated, for example, in the world of equities. However, since instrument correlation exists to a large degree in forex trading, we’ll talk about this topic in the context of forex pairs.

While double trading two pairs that are correlated may seem like a great reward opportunity, it can also result in double the amount of losses, should the trade not play out as expected. As with any trading-related decision, it is always advised to gain a thorough understanding of the underlying asset, its movements, and its correlation to other assets before engaging in taking such a risk. Trading is an art that involves weighing risk-to-reward ratios, and doubling your wager can disproportionately increase your risk while only providing marginal additional rewards. Exercising restraint and caution when placing trades is always suggested and not doubling your risk by placing trades on two correlated pairs is one way to ensure you don’t overextend yourself when trading.

Positive Correlation Trading Example: AUDUSD & NZDUSD

Trading can be a tricky business, and no one wants to double their risk exposure. Fortunately, there are measures that traders can take to help reduce the risks associated with trading. One of the first steps when navigating the forex markets is to identify currency pairs that are correlated to one another.

Let’s look at AUDUSD and NZDUSD, as an example. These two pairs typically trade together with a strong correlation above 0.80 — usually in the 0.90 range. If these two pairs are traded together at once, they could result in a trader doubling their risk exposure due to their correlation. To avoid this situation, traders should become familiar with correlation analysis and use the information provided in correlation reports to determine which currencies may be highly correlated so that they can make informed decisions regarding their trading strategies and avoid doubling their risk exposure when trading multiple pairs at once.

As you can see, over the last 100 periods in the 4-hour timeframe, AUDUSD and NZDUSD have a +0.92 correlation. Let’s take a look at the charts.

Here’s an overlay of the AUDUSD in blue and the NZDUSD in orange. The pairs largely move together in tandem.

As for risk, it’s easy to see that opening a position on both pairs would effectively double your risk exposure. If you buy one lot of AUDUSD and then another of NZDUSD, you are essentially buying two lots of AUDUSD — thus, increasing your risk two-fold. If your AUDUSD gets stopped out, your NZDUSD trade will likely get stopped out as well.

Conversely, if you went long on one pair and short on the other, you’ve made an extremely counterproductive move. This means that any increase in one pair will likely be offset by a decrease in the other, thus effectively reducing your net gain.

Negative Correlation Trading Example: GBPUSD & USDCHF

We’ll take a look at another example, the GBPUSD, and the USDCHF, which have a high negative correlation. If one goes one way, the other usually goes the opposite direction. As you can see, over the last 100 periods in the 4-hour timeframe, GBPUSD and USDCHF have a -0.84 correlation.

Let’s take a look at the charts. Here’s an overlay of the GBPUSD in blue and the USDCHF in orange. The pairs largely move opposite one another.

Taking the opposite positions on two negatively correlated instruments is like taking the same position on two positively correlated instruments. If you went long GBPUSD and short USDCHF at the same time, you’d effectively be doubling your risk exposure.

Similarly, if you place positions in opposite directions on those two pairs and you get stopped out on one, you’ll likely get stopped out on the other, as well.

While trading offers opportunities to make big profits, it’s important to avoid doubling your risk exposure by placing trades on two correlated pairs. By doing so, you could end up losing more money than you originally invested. To avoid this, be sure to diversify your portfolio and only trade instruments that are not highly correlated. This will help you mitigate risk and maximize your chances of success in the market.

 

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.