The Correlation Code

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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