When you are simultaneously trading multiple currency pairs in your trading account, always make sure you’re aware of your RISK EXPOSURE.
You might believe that you’re spreading or diversifying your risk by trading in different pairs, but many pairs tend to move in the same direction.
So instead of reducing risk, you are magnifying your risk! Unknowingly, you are actually exposing yourself to MORE risk.
This is known as overexposure.
Let’s look at an example involving two highly correlated pairs within a one week period: the EUR/USD and GBP/USD.
Based on the table, with a sexy correlation coefficient of 0.94, there’s obviously a high correlation in this particular pair. EUR/USD is the peanut butter to GBP/USD‘s jelly! Like oil and water. Like Ben & Jerry’s!
Okay, you get the picture. The point is that the two pairs hold hands, sing “Kum Bay Yah”, and skip together.
Currency Correlation Example #1: EUR/USD and GBP/USD
To prove to you that the numbers don’t lie, here are their 4-hour charts. Notice how they both moved in the same direction…down.
Returning to the subject of risk, we can see that opening a position in both the EUR/USD and the GBP/USD is the same as doubling up on a position.For example, if you bought 1 lot of EUR/USD and bought 1 lot of GBP/USD, you’re basically buying 2 lots of EUR/USD, because both the EUR/USD and GBP/USD would move in the same direction anyway.
In other words, you are INCREASING your risk. If you buy EUR/USD and GBP/USD, you don’t get two chances to be wrong!
All you get is one chance because if EUR/USD falls and you get stopped out, GBP/USD will most likely fall and stop you out also (or vice versa).
You also wouldn’t want to buy EUR/USD and sell GBP/USD at the same time because if EUR/USD skyrockets, then GBP/USD would probably skyrocket also and where does this leave you?
If you think your profit or loss will always be zero, then you’re wrong. EUR/USD and GBP/USD have different pip values and just because they are highly correlated doesn’t mean they always move in the same exact pip range.
Volatility within currency pairs is fickle.EUR/USD can skyrocket 200 pips, while GBP/USD only goes up 190 pips. If this happens, the losses from your GBP/USD trade (because you were short), will eat up most, if not all, of the gains from your EUR/USD trade.
Now let’s imagine that EUR/USD was the pair that moved up 190 pips, and GBP/USD had the bigger move of 200 pips. You would’ve definitely had a LOSS!
Going long one currency pair and going short another currency pair that are highly correlated is extremely counterproductive.
More than paying for the spread twice, you minimize your gain because one pair eats into the other pair’s profits.
And even worse, you could end up losing due to the different pip values and ever-changing volatility of currency pairs.
Currency Correlation Example #2: EUR/USD and USD/CHF
Let’s take a look at another example. This time with the EUR/USD and USD/CHF.
While we just saw a strong positive correlation with the GBP/USD, the EUR/USD has a very negative correlation with the USD/CHF.
If we look at its one-week correlation, it has a perfect correlation coefficient of -1.00. It doesn’t get any more opposite than this folks! Instead of Ben & Jerry’s, they’re Tom and Jerry!
EUR/USD and USD/CHF are like fire and water, Bugs Bunny and Elmer Fudd. Superman and kryptonite, Boston Celtics and Los Angeles Lakers, Manchester United and Liverpool.
These two pairs totally move in opposite directions. Check out the charts:
Taking opposite positions on the two negatively correlated pairs would be similar to taking the same position on two highly positive correlated pairs.
Buying EUR/USD and selling USD/CHF would be the same as doubling up on a position.
For example, if you bought 1 lot of EUR/USD and sold 1 lot of USD/CHF, you’re basically buying 2 lots of EUR/USD, because if EUR/USD goes up, then USD/CHF goes down, and you’d be making money on both pairs.It’s important to recognize though that you have INCREASED your risk exposure in your trading account if you do this.
Returning to the example with you being long EUR/USD and short USD/CHF, if EUR/USD actually dropped like a rock, most likely both of your trades would be stopped out resulting in two losses.
You could’ve minimized your loss by simply deciding to go long EUR/USD OR go short USD/CHF, instead of doing both.
Because the two pairs move in opposite directions like they hate each other’s guts, one side will make money, but the other will lose money.
So you either end up with little gain because one pair eats into the other pair’s profits.
Or you could simply end up with a loss due to each pair’s different pip values and volatility ranges.