A correlation between currencies is the relationship between the price trends of said currency, so when we mention correlation between currency crosses we mean the same thing, only that it applies to pairs rather than to single currencies. The correlation becomes important when you want to invest in Forex by considering more than one currency pair, with the intent to consider the reciprocal reactions that are created between two or more elements taken into consideration. In technical jargon, we talk about operations. When we want to consider the operation on two or three crosses at the same time, we will have to consider several factors including the correlations between them. We specify that for elements we mean currency pairs and that it is not advisable to study the correlations between more than three currency pairs for the same purpose. For example, you study the correlations between EUR/USD, USD/JPY and EUR/JPY, and also study the correlations between these and others with GBP. This is complicated and a bit too much so we recommend staying in the “triangle” type AB, BC, AC.
Elements to Consider
To carry out a study on three currency crosses at the same time we have to take the following elements into consideration:
- Correlations between the same crosses
- Cross price trend
Let’s deepen the first point. We have already analysed rollover before, but let’s briefly repeat that this is a daily click that allows you to receive positive and negative prizes for maintaining your position. The trend of cross prices is almost an obvious fact, but it is always good to never leave anything to chance and reiterate the most important concepts.
Now be careful because as we said a moment ago, it’s possible to take for granted aspects that affect the individual currency cross. The characteristics that influence the trend of the individual crosses vary from pair to pair, so we must always keep them in mind, especially when preparing to make a correlation.
For example, cross trends may be influenced by the economic conditions of the respective countries, carry trade operations, the diversity of the markets they present, transaction volumes and others. Each of these elements can influence the single currency. Let’s take a closer look.
- Carry trade is a financial transaction in which funds are procured in a country with a low cost (low interest rate) and these funds are used in a country with a high interest rate. For example, if we borrowed Yen and paid 1% (low), we could convert them to AUD (Australian Dollars) which makes 7-8%. The transaction is very convenient but presents a risk due to the exchange rate. If before the expiry of our speculative transaction in Australia, the Yen is re-evaluated for more than the difference in yield, the operation becomes a loss. The carry trade, however, tends to depress the exchange rate of the Yen, since it involves the sale of Yen against other currencies, thus enhancing the convenience of the transaction.
- The diversity of the markets is due to the different import, export and production strategies due to the type of raw materials available, the type of products and the demand both internal and external.
The correlation, simply recapitulating, is trading on multiple currency pairs simultaneously. For this reason, it is necessary to follow the individual currencies more closely, then the currency pairs that comprise them. The correlation takes place to contrast the differences between the various elements, as well as to highlight the points in common. In practice, it is a matter of understanding how currency pairs behave in the presence of certain conditions, such as those of the market that affect both the reference markets, how they respond to the currency that is part of the pair as well as others. The best strategy is to operate with at least three crosses, two of which are directly or inversely correlated (also considering rollover rates) and one third to cover set on a positive rollover transaction. Refer to the first part of the article in which we considered price and rollover trends. These two are necessary elements for the study of currency pairs and in the planning of an investment based on the correlation between currencies in Forex.
For this reason there exist correlation tables called “Daily Correlation”. On the table we’ll find pairs placed both on a horizontal and vertical line, in order to create points of contact. The cross between two equal crosses will be 100. We will find positive and also negative data. We can use the following rules:
- If the correlation is high, i.e., the data is above 80 and positive (there is no -), it means that the currency crosses move in the same direction
- If the correlation is high, i.e., the data is above 80 and negative (there is sign -), it means that the crosses move in the opposite direction (inversely related)
- If the correlation is low, i.e., the data is below 60, the cross does not move in the same direction
For example, if the cross is USD/JPY it shows a data (correlation index) of -89 will mean that it moves in the opposite direction to EUR/USD (100). If the GBP/USD scores -40, it means that it does not move in the same direction as EUR/USD. Again, if EUR/GBP scores 83, it means that it is moving in the same direction as EUR/USD.
Here is an example of a Correlation Daily table or Correlation of Currencies in Forex.
Here is yet another type:
As you can see, the intersection of two equal currencies gives a correlation index of 100. The squares in pink are the negative ones, those below -60 are marked in dark pink. Boxes above 80 are highlighted in dark green.
Go to the next lesson – Carry Trade, an in-depth study