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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.

USDCAD and USDJPY have high positive correlation

USDCAD and USDJPY have high 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.

USDCAD and USDJPY correlation as calculated by Mataf.net

USDCAD and USDJPY correlation as calculated by Mataf.net | Source: Mataf.net

 

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.)

Director, TerraSeeds Market Technician Pte Ltd. Trader, investor. @sohtionghum was picked ‘Top 70 Forex Twitter in 2015’.

“Dear reader, I do not have a financial license to give advice. I do not know you the reader. Your financial objective and risk tolerance may be different from mine. I am not responsible for any consequence of your action.

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3 thoughts on “Forex correlation: have you really diversified your trades?”

  1. Benson Ang says:

    HI Mr SOh, thank you very much for sharing this Mataf site, its definitely very useful to check the co-relationship of our trading pairs to make sure we diversify our trading pairs well.

    But can i check with you on the Num Periods (located below the Currency selection chart, is 50 the default as shown in the site?

    1. Soh Tiong Hum says:

      Hi Benson, the default value is 50 but it can be personalised. If you were interested in correlation in the past 24 hours for example, you could go to the hourly chart correlation and set the number of data points as 24. See explanation here.

  2. Benson Ang says:

    thank you Mr Soh. =)

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