The risk of currency correlations is similar to having all your portfolio invested in oil stocks. A drop in the oil price will lead to all their share prices dropping. The same thing can happen with currency pairs. If you happen to hold several currencies which can be influenced by the same event, you are risking all your positions losing value at the same time. Understanding correlations is therefore important!
Currency correlations describe the movement of currency pairs in tandem due to the same event. Currency pairs which react the same way to a specific piece of news have a high correlation. When two currency pairs move in opposite directions, we say they have a negative correlation. When they move in the same direction, they are positively correlated.
More specifically, a correlation is a statistical measure of how two items move in relation to each other. In this article we are looking at currency correlations. Different currency pairs can move in the same way due to a correlation in what influences their prices.
Although Forex traders starting off may only trade one currency pair as they learn the ropes, others may trade several. Knowing which currency pairs may be interlinked is important, this ensure you are not over-exposed to a particular kind of risk for the currency pairs you hold.
Common correlations are the US dollar and ‘risk off’. When a world event occurs, such as Lehman Brothers going bankrupt, investors flee to safe havens such as the US dollar. As a result, currencies paired up against the US dollar suffer. Less well-known correlations are the ‘Comdolls’. They are so named as they involve the dollar named commodity currencies such as the Australian dollar, Canadian dollar and the New Zealand dollar. All these currencies are influenced by commodity prices as their economies are overly dependent on revenues from these assets. As a result, a drop in commodity prices will usually lead to a fall in their currencies.
Although we have mentioned that currency correlations do exist, you should be ready for changes. The world is so interconnected that an economic event, such as central bank monetary policies, in a far away country can influence correlations. Although a return to the norm (i.e. historical trends) can usually be expected, you should not be surprised if short-term correlations are vastly different from long-term correlations.
Exposing yourself to several currency pairs which are closely correlated is harmful. If a factor (such as the oil price) turns negative, it could affect all your positions. Therefore you should consider your risk management strategy, Understanding how your various currencies are interconnected will allow you to quantify your risk.
Another form of risk management is diversification. If you understand which currencies are correlated, you can work out which are at risk of reacting negatively to the same single event. You can reduce your risk by trading currency pairs which are not correlated.
So far, we have spoken about the risk of currency correlations, but what about the opportunity? If you want to make money you should start by not losing any. The second step is understanding what you are trading and the risk involved. If a higher risk is identified, it may be an opportunity for a higher profit. Consider if the oil price is markedly lower than it has been. This may be an opportunity to buy a commodity-exposed currency such as the Canadian dollar on the cheap. This is an example of using currency correlations to your advantage, something which comes naturally to good traders.
Every Forex trader is looking to make a profit. That is a given. Yet few aspiring traders pay enough attention to risk management. Identifying and understanding the risk you are taking is paramount to become a profitable trader. Currency correlations highlight the risk of a lack of diversification, which your Forex portfolio may have. Identifying these risks and taking steps to mitigate these, will ensure you avoid a few landmines and win at trading!