The Correlation Code

Archive for the ‘Forex Correlation’ Category

Making money off of Forex trading is, at the very simplest level, about taking positions on currencies. You can take a positive position (you expect one currency to rise relative to the other) or a negative position with the expectation of short selling. If the currency valuation doesn’t move, you don’t make money. If the currency moves in a way you weren’t expecting, you may well lose money.

What currency correlations do in forex trading is allow you to make more money off of a given move without exposing yourself to more risk if the currency position moves in an unanticipated direction. It also allows you to make some sophisticated strategies based on negative and positive correlations.

As a brief refresher, correlations range from 1 (the two currency pairs move in the same direction nearly all of the time) to 0 (there is no correlation between the currency pairs and they move independently of one another) to -1 (when one currency pair moves up, the other pair moves down).

Here are some very basic strategies for utilizing correlations in your forex strategy:

1) Don’t make the same play on opposite correlations. This is a fancy way to say "If you’re picking USD to rise against the EUR, don’t pick it to rise against the Swiss Franc (CHF)". Because those two currency pairs have a short and long term correlation of -0.99, taking dollar in both sides of the equation is effectively the same as taking no position at all.

Instead, you should invest in the Dollar to rise against the Euro, and the Swiss Franc to rise against the dollar. This can effectively double your play on the same movement. A more complicated strategy is to take a short sale position on the US dollar against the Swiss Franc, if you want to keep your currency trades denominated in dollars.

2) Look at both short term and long term correlation rates when making your strategic decisions. The CHF/USD and USD/EUR correlation is a strange one in that it’s consistent in long term and short term plays. Generally, the farther away from 0 a correlation is, the more predictable the outcome is. While the USD/CAD and USD/EUR have a correlation of about 0.7 in short term trades, over months and quarters, that correlation drops to about 0.44. As a position play, you should be aware of historical trends, and what events can cause the two currency pairs to decouple. In the Canadian Dollar’s case, that decoupling usually comes from a jolt in prices for timber and oil, which are two of Canada’s major exports.

What this means is that no matter how tempting it is to use a correlation as a ‘no brainer pick’, you really do need to pay attention to the underlying factors driving the currency markets. Correlations are a strong indicator, but they are not a guarantee, and they do change over time.

3) Look for long term trends in correlations. While nearly everyone and their uncle is advocating playing forex as a day trader’s market, talking about 5 figure monthly incomes off of well timed trades, there is another strategy for doing forex trading, and correlations are important to it as well. This is the long term position trade, rather than trying to run on day by day volatility.

A long term position trade is a position held for a couple of months; you’re looking for situations where you expect a currency pair valuation to jump from a regular, seasonal change. The classic example of this, before the Euro became the de-facto currency of Europe, was the German Mark, which had a historical drop in prices in late July and the first week in August, because nearly everyone in Germany took vacations at the same time, and bought currencies for other parts of Europe to go vacationing with. There are similar trends in currencies around the world; the Australian dollar takes a drop every October for the same reason – October through January is the summer vacation season in Australia, and affluent Australians travel to other parts of the world to enjoy their time off.

Mapping these to correlations can help you make seasonally timed (and less frantic) forex trades and will tell you when to make certain trades or avoid others.

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We’ve discussed how correlations can be useful in planning strategic forex trades. Getting proper correlation information is also important – and surprisingly, it’s something you can do for yourself, for free. It’s not even that difficult, though you will want a spreadsheet program and a charting program. We’ll give examples of what to do in both Excel and Open Office.

You’ll need a charting program that downloads daily currency prices; there are plenty of them, and most will save the data in either comma separated values or native .xls formats. You’ll need to import the data into Excel; the simple way to do this is to simply open the file and cut and paste. You can also get a little bit clever and tell your charting program to overwrite the existing file after each download, and link to the file within Excel, by opening the data file and Excel at the same time, typing the equals sign in a cell, and then clicking on the appropriate cell in the data file. Repeat this for each currency price that you want to track.

What you’ll end up with is a series of columns pulled from the currency price pairs. (Be sure to label them). You’ll want to pull historical data running back a day, a week, two weeks, a month, three months and six months.

Now, underneath each of the columns, you’re going to use the Excel =CORREL() function. Enter =CORREL( and then select the first column of data, then enter a comma and select the second column of data.

If your data were in the columns A1 through A7 and B1 through B7, the final formula would look like this:
=CORREL(A1:A7,B1:B7)

The way that CORREL works is that it takes the values in the ranges and runs a standard statistical correlation (which is X-X * Y-Y over the square root of X-X^2 * Y-Y^2).  The CORREL function requires that both sets of data have the same number of values in them, otherwise it will return an #N/A error. There are a few cases where CORREL will provide a #DIV/0 error, but you’re unlikely to run into them.

Now, to be real clever about this, repeat it for every set of currency pairs you want to track the correlations on. This will take about an hour or so to set up in most cases, and if you do it right, can automatically update every time you pull down a new range of currency prices.

If you’re deep into analysis, instead of using full ranges on the =CORREL() function, you can do this for every item that comes through and build a general trend analysis tool. Feeding these numbers into Excel’s charting functions can even give you regular charts on correlations – and setting up charts means going to the Charts and Graphs Wizard and selecting which cells you want to show on the data plot.

The aim here is to give you a quick glance picture that you understand about the correlation involved in a set of currency pairs, so that you can make informed decisions in a short period of time; though correlations aren’t going to change much on the ‘five minute plot’ that day traders live on, having the data update automatically, and having the summary in place (along with date and time traces for when things changed) can let you back track the correlation’s changes with news announcements, and see what, if anything, is driving them. This can be useful information for making a future forex trade later.

You can also do this sort of correlation mapping with tools other than Excel. Open Office also has a =CORREL() function, but it uses a semicolon (;) rather than a comma (,) for its formatting. It has the same limitations that the =CORREL() function in Excel does.

Technorati Tags: Forex Correlation, fx correlation table

A few years ago, people hesitated on a career that dealt with the Stock Market. Most people were afraid of losing invested money since they were not sure how to manage their shares of stocks properly. The same thing went for the Foreign Exchange Market. The pairing of currencies was really quite difficult to understand. At the present time, people are getting the hang of the Stock Market especially now that there are references available in the Internet and so is automated software that can give assistance to their needs.

There is one topic though that needs further discussion and it s all about Forex Correlation. This is all about the relationship between a pair of currencies over a given period of time. Now the correlation here is the measurement between a negative with a positive range. Bear in mind that the positive range is when there are two different currency units that move in similar directions. At the same time, when you speak of a negative range, the currencies move in opposite directions.

Correlation exists because the market which deals with the foreign exchange or Forex is made up of trading the pairs of currencies as one group. These pairs, like the USD with the EUR, are priced on the existing value of one currency and then divided by the other currency. What you are actually doing here is that you buy one currency and at the same time, you sell the other currency. Each pair that you trade at is two different ones and it is not to be considered as one stock or one commodity similar to how you consider stocks.

Now that the USD is not performing well in the global market while the EUR is still stable, what you have here is a negative state. You buy using the USD and you sell using the EUR which in the long run would give you capital gains and further strengthen your investment portfolio. Such a tandem would permit you to seek a wider range of options. They show a high level of Forex Correlation.

In any pairing you do, it is wise and of course highly recommended that you study the market first before you start pairing currencies. Understanding forex correlation is a key skill to consistently making profits trading forex.

To find out more about how forex correlation can help you be a more profitable forex trader, check out the Correlation Code.

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