Correlation Trading Explained

Understanding correlation helps manage risk and find opportunities.

What is Correlation?


Definition

• How two pairs move in relation to each other
• Measured from -1 to +1
• Changes over time

Correlation Values

• +1.0: Perfect positive (move same direction)
• 0: No relationship
• -1.0: Perfect negative (move opposite)

Common Correlations

Highly Positive (+0.7 to +1.0)

• EUR/USD and GBP/USD
• AUD/USD and NZD/USD
• EUR/JPY and GBP/JPY

Highly Negative (-0.7 to -1.0)

• EUR/USD and USD/CHF
• GBP/USD and USD/CHF
• AUD/USD and USD/CAD (sometimes)

Variable Correlation

• USD/JPY and Gold (risk-off relationship)
• AUD/USD and Gold (commodity link)
• USD/CAD and Oil prices

Risk Management Applications

Avoiding Double Exposure

• Going long EUR/USD AND GBP/USD
• Essentially doubling your USD short
• If USD strengthens, both positions lose
• Reduce size on each or pick one

Hedging with Correlation

• Long EUR/USD, short USD/CHF
• Positions somewhat offset each other
• Reduces but does not eliminate risk

Portfolio Diversification

• Trade uncorrelated pairs
• Balance across currency groups
• Reduce overall portfolio volatility

Trading Opportunities

Correlation Breakdown

• When correlated pairs diverge
• One may be lagging
• Mean reversion opportunity
• Requires experience to trade

Confirmation Trading

• Check correlated pairs for agreement
• EUR/USD bullish setup
• Check if GBP/USD also bullish
• Alignment = higher conviction

Key Takeaways

• Correlations are not permanent
• Use for risk management primarily
• Correlated positions = increased risk
• Uncorrelated portfolio = smoother equity curve