How Forex Correlations Secretly Affect Your Trading Risk and Profits

daily forex correlation table
Daily Forex Correlation Table (not all pairs included). ttps://www.mataf.net

Many Forex traders trade a number of Forex pairs, holding trades in multiple pairs at the same time. If you trade multiple pairs at the same time, you may be exposed to more or less risk than they think. The reason is correlation (for a basic primer on Forex, see What You Need to Know About Forex).

What is Correlation

Correlation is a number between -100 and 100 (or -1 and 1) showing how the direction of one asset moves in relation to another.

If two pairs have a -100 correlation, they move in opposite directions. When one goes up, the other goes down. A 100 correlation means they move in sync; when one goes up, so does the other.

When the correlation is negative, it's known as an inverse or negative correlation. If the correlation is a positive number, it's a positive correlation.

Correlations above 80, or below -80, are considered high and noteworthy because they may be "secretly" increasing or decreasing your risk.

A correlation of 0 means there is no relationship between how one pair moves relative to the other. Correlations between -60 and 60 mean the relationship is weak; if one pair has a 50 correlation to another pair, if one goes up, the other may go up, but not necessarily. 

Correlation does not account for the magnitude each pair moves. One pair could be 10 times as volatile as the other, but as long as they move in the same (or opposite) direction they will be highly correlated.

The attached chart shows a daily correlation table from Mataf. Find the two pairs you want the correlation for on the x- and y-axis and find where they meet on the grid. Some of the very high correlations, over 90, are circled on the chart. Correlations can be calculated on all time frames. The daily correlation is important, but for day trades the correlations on lower time frames may be relevant as well.

Correlations are not fixed and are monitored regularly. A strong or weak correlation now doesn't mean it will stay that way.

How Correlation Can Increase Risk When Holding Multiple Trades

If Forex pairs are highly correlated (positive or inverse) it's likely you will see similar trades in each. 

If the AUDJPY and CADJPY have a 95 correlation it means they typically move in the same direction. Since they move in the same direction, if you see buy signal in the AUDJPY there may also be one in the CADJPY (not always, though; they are correlated, not identical). 

If you buy the AUDJPY and also decide to buy the CADJPY, you have bought the CAD and AUD relative to the JPY. You have sold the JPY twice, effectively doubling risk, or doubling potential profit based on what the JPY does.

Assume you risk 1% of your account on each trade, with the two trades resulting in a 2% risk to your account. Taking multiple trades is fine, but realize that you have effectively taken the same trade twice. If the JPY moves in your favor (down, and AUD and CAD go up) you make double what you would have if you only traded one of the pairs. If the JPY moves against you, you stand to lose 2% though.

Beware when taking correlated trades, as you may be doubling your risk (and possible profits) without noticing it.

 

If your trading plan says to risk 1% of account equity per trade, then you should only take one of these trades. Or risk 0.5% in each. Since they are almost the same trade, trading both could be a violation of your risk management rules (of course it is up to you if you wish to do this).

Even in highly correlated pairs, the trade setup in one pair is often slightly better than the other. Pick the one with the highest reward:risk or best probability of a profit.

See How Much Money Can I Make Forex Day Trading? for more on forex day trading profits.

How Correlation Can Decrease Risk When Holding Multiple Trades

Correlations are a way to establishes hedges; where the losses in one trade are offset by the gains in another. Hedging is fine, but some traders may be doing it unwittingly. 

Continuing with the example, let's say you get a buy signal in the AUDJPY and a sell signal in the CADJPY.

Remember, even though they move in a similar fashion, they won't be identical, so this situation is possible. If you take both trades, realize you won't likely win on both. 

If your reward on each trade is bigger than the risk (you try to make 2% on each by only risking 1%), losing on one (-1%) is fine, because if the target is reached on the other (+2%) you net 1%. If you expect to win both, you may be disappointed.

On the attached chart the EURUSD and USDCAD have a -90.8 correlation. As one moves up it is likely the other will move down. If you buy the EURUSD and the USDCAD, one is likely to move up while the other moves down. If you take both these trades, you could win or lose on both, or more likely you will win on one and lose on the other since the trades form a partial hedge*.

If you buy (sell) the EURUSD and sell (buy) the USDCAD, you have the situation discussed in the section above, where you have sold (bought) the USD twice, and may be increasing your risk. 

See Best Time of Day to Day Trade the EURUSD for more insights on the EURUSD.

Final Word

Be aware of correlations between pairs that you trade. You may be exposed to more or less risk than you think. Usually high correlations are found between pairs which contain one of the same currencies (JPY and USD in examples above). Correlations change over time, so monitor them regularly. 

*Unless precisely calculated, most hedges of this nature are partial, because the trader hasn't accounted for overall volatility. If one pair is more volatile than another, one trade may move 50 pips higher, while the other only declines by 20 pips. Therefore, losses in one may not be completely offset by gains in another or vice versa.