Forex correlation: have you really diversified your trades?
USDCAD USDJPY movement an example of FX correlation
If you thought that these two charts – USDCAD hourly on top and USDJPY hourly below – look very similar, you might be on to something. The two currency pairs are moving almost in tandem. Both showing USD strengthening. Despite minor differences, the peaks and troughs match very well.
This is an example of strong positive correlation.
How does correlation work?
Here is a tool from forex site Mataf.net that measures forex correlation. According to Mataf,
The correlation of currencies allows for better evaluation of the risk of a combination of positions. Correlation measures the relationship existing between two currency pairs. For example, it enables us to know whether two currency pairs are going to move in a similar way or not.
Two correlated currencies will have a coefficient close to 100 if they move in the same direction and of -100 if they move in opposite directions. A correlation close to 0 shows that the movements in the two currency pairs are not related.
USDCAD and USDJPY has a weekly correlation of 83.2. One week is just about the duration of the segment by the two orange vertical lines in the chart above. So if you thought USDCAD and USDJPY were moving together, your eyes are sharp and your senses serve you well.
If the correlation is high (above 80) and positive then the currencies move in the same way.
Managing your forex risks
Now this is what Mataf says as well,
It may be important to know whether the open positions in a portfolio are correlated. If you have open trades in three currency pairs which are strongly correlated (for example EURUSD, USDCHF and USDNOK), you must anticipate the fact that if one of the positions reaches its stop-loss, then the other two are very likely to also be loss-making positions. In this case, it is important to adjust the size of the positions in order to avoid a serious loss.
I encourage you to have fun with this tool, try it and give it a thought. (Clue: if you thought you have diversified your risk by doing two different trades with USDCAD and USDJPY, you might be wrong.)