Written by: Chris Beauchamp | Chief Market Analyst, London
What is currency correlation in forex?
A currency correlation in forex is a positive or negative relationship between two separate currency pairs. A positive correlation means that two currency pairs move in tandem, and a negative correlation means that they move in opposite directions.
Correlations can provide opportunities to realize a greater profit, or they can be used to hedge your forex positions and exposure to risk. If you assume that one currency pair will continue to move alongside or against another, then you can either open another position in attempt to maximize your profits, or you could open another position to hedge your current exposure in case volatility increases in the market.
However, if your forecasts are wrong when trading currency correlations, or if the markets move in an unexpected way, you could incur a steeper loss, or your hedge could be less effective than anticipated.
The strength of a currency correlation depends on the time of day, and the current trading volumes in the markets for both currency pairs. For example, pairs which include the US dollar will often be more active during the US market hours of 7am to 4pm EST, and pairs with the euro or the pound will be more active between 3am and 12pm EST – when the European and British markets are open.
Learn more about the best times to trade forex
What is the correlation coefficient?
The correlation coefficient is used in pairs trading, and it measures the correlation between different assets – in this case, currency pairs. It ranges from 1 to -1, with 1 representing a perfect positive correlation and -1 representing a perfect negative correlation. If the coefficient value is 0, it means that there is no correlation between the price movements of different currency pairs.
The Pearson correlation coefficient is the most used measure of currency correlations in the forex market, but others include the intraclass correlation and the rank correlation. In the context of currency correlations, the Pearson correlation coefficient is a measure of the strength of a linear relationship between two different forex pairs. Many traders will use a spreadsheet computer program to calculate the Pearson correlation coefficient, because the method for doing so manually is very complex.
What are the most highly correlated currency pairs?
The most highly correlated currency pairs are usually those with close economic ties. For example, EUR/USD and GBP/USD are often positively correlated because of the close relationship between the euro and the British pound – including their geographic proximity, and their status as two of the world’s most widely-held reserve currencies.
The table below gives examples of the correlations between some of the most traded currencies in the world. The correlations were calculated over a 3-month period on March 15th, 2024:
How to trade on forex pair correlations
You can trade on forex pair correlations by identifying which currency pairs have a positive or negative correlation to each other. In the conventional sense, you could open two of the same positions if the correlation was positive, or two opposing positions if the correlation was negative.
This is because if there was a perfect negative correlation between USD/CAD and AUD/USD, having a long position on both pairs would effectively cancel each other out since the pairs would be assumed to move in opposing directions. But, if the correlation was perfectly positive, separate long positions on different pairs might help to increase your profits – or it could increase your losses if your forecasts are incorrect.
Traders will typically take positions on correlated pairs in order to diversify themselves while maintaining the same overall direction – either up or down. This could be to protect themselves from the risk of a single pair moving against them, as they will still have the opportunity to profit on the other pair if that happens. It should be stated, that perfectly correlated currency pairs are very rare, and there is always a degree of uncertainty when trading the financial markets.
You can also trade on forex pair correlations to hedge your risk on your active currency trades. For example, you could take out a long position on USD/CHF to hedge any losses you might incur on an active long EUR/USD position or vice versa. That’s because these two currency pairs have a strong historical negative correlation.
Let’s say you’ve put $10 per point of movement on EUR/USD. To hedge your exposure, you put $8.50 per point of movement on USD/CHF and both currency pairs move 10 points. EUR/USD falls 10 points, resulting in a -$100 loss but, given the negative correlation, USD/CHF rises 10 points for an $85 gain.
While there is still a net loss of -$15, the $85 profit from the USD/CHF position meant that the loss was not -$100, as if you had only opened the EUR/USD trade. Alternatively, you could open two opposite positions on two positively correlated pairs, and the gains on one would offset the losses on the other.
An example of a positively correlated hedge would be if you thought that EUR/USD and GBP/USD were about to break their positive correlation. This could be because the Bank of England is expected to dramatically alter interest rates, or there is economic slowdown expected in the eurozone. If this was the case, you might choose to take a temporary short position on GBP/USD to offset any losses on your long EUR/USD position.
Learn more about how to short forex
EUR/USD and GBP/USD correlation trade example
EUR/USD and GBP/USD are positively correlated forex pairs, with an increase or decrease in one often seeing an equal increase of decrease in the other. The reason for this correlation is the close relationship between the US dollar, the euro and the pound – with these three currencies being entwined by the strong economic ties between each of their respective economies.
As an example of the positive correlation between these two pairs, you could open two long positions on the EUR/USD and the GBP/USD currency pairs. If the correlation is currently present in the market and if the pairs increased in price, you could potentially increase your profit.
Equally, you could open two short positions on these pairs if you believed that the price of one was about to fall. If the positive correlation was currently strong, you would expect the price of the other to fall alongside it.
However, in both examples, losses would be magnified as well if both pairs move together against your position.
Commodities correlated with currencies
The value of some currencies is not only correlated to the value of other currencies, but it is also correlated to the price of commodities. This is particularly true if a country is a net exporter of a particular commodity, such as crude oil or gold.
CAD and crude oil
The price of the Canadian dollar is often positively correlated with the price of oil. Typically, an increase in the price of oil will see an increase in the value of the Canadian dollar on the forex market. This is often reflected in the movements the USD/CAD pair because oil is traded in the US dollar, which is generally negatively correlated with the price of oil.
This means that when the price of the US dollar increases, the price of oil tends to decrease. It also means that an increase in the price of oil usually causes a decrease in the value of the US dollar. As a result, traders could use this information to take a long position on the Canadian dollar – such as in the CAD/JPY pair – when they believe oil will rise, or take a short position on the US dollar – such as in the USD/CAD pair – under the same assumptions.
AUD and gold
The price of gold is often positively correlated with the price of the Australian dollar, especially in the AUD/USD currency pair. Because Australia is a net exporter of gold, when the price of gold appreciates so does the price of AUD/USD; when gold slumps, AUD/USD also slumps.
If the price of AUD/USD rises, you would need to sell more US dollars in order to buy a single Australian dollar – which means that the Australian dollar is strengthening compared to the US dollar.
Similar to the correlation between the Canadian dollar and crude oil, the value of the Australian dollar and gold are usually positively correlated, and the price of the US dollar is usually negatively correlated to both.
The Australian dollar is known as a commodity currency because its value is tied closely to the value of Australia’s commodity exports such as copper, coal, agricultural products and gold. These exports are also often correlated to the value of the Australian dollar, but gold has arguably the greatest positive correlation with the Australian dollar.
Forex pair correlations summed up
- Currency correlations can be either positive or negative
- Positive correlations mean that two currency pairs will tend to move in the same direction
- Negative correlations mean that two currency pairs will tend to move in opposing directions
- Correlations – whether positive or negative – offer an opportunity to realize a greater profit or to hedge your exposure
- Currency can also be correlated with the value of commodity exports, such as oil or goldPublication date:
2024-06-11 09:45:56 (GMT)