Have you ever noticed that when a certain currency pair rises, another currency pair falls? Or how about when that same currency pair falls, another currency pair seems to copy it and falls also?
If the answer is “yes,” you’ve just witnessed currency correlation in action!
If you answered “no,” you need to stop doing less important things like sleeping, eating, playing FarmVille or Angry Birds, and instead spend more time watching charts.
But no worries because we’re going to start with the basics and break it down yo…
The first half… easy. Currency. No explanation needed.
The second half. Still easy. Correlation: a relationship between two things.
In the financial world, correlation is a statistical measure of how two securities move in relation to each other.
Currency correlation, then, tells us whether two currency pairs move in the same, opposite, or totally random direction, over some period of time.
When trading currencies, it’s important to remember that since currencies are traded in pairs, that no single currency pair is ever totally isolated. (Did we just confuse you with our “currencies” tongue-twister sentence there?)
Unless you plan on trading just one pair at a time, it’s crucial that you understand how different currency pairs move in relation to each other, especially if you’re not familiar with how currency correlations can affect the amount of risk you’re exposing your trading account to.
If you don’t know what the heck you’re doing when trading multiple pairs simultaneously in your trading account, you can get KILLED! Murdefied! Destroyed! We can’t stress this enough.
In this lesson, you’ll learn what currency correlation is and how you can use it to help you become a smarter trader and make more responsible risk management decisions.
Correlation is computed into what is known as the correlation coefficient, which ranges between -1 and +1.
Perfect positive correlation (a correlation coefficient of +1) implies that the two currency pairs will move in the same direction 100% of the time.
Perfect negative correlation (a correlation coefficient of -1) means that the two currency pairs will move in the opposite direction 100% of the time.
If the correlation is 0, the movements between two currency pairs is said to have uh ZERO or NO correlation, they are completely independent and random from each other. We have no idea how one pair will move in relation to the other.