Different currency pairs can often be seen to move together, sharing a similar chart pattern and increasing and decreasing in value at the same time. These can be seen to be correlated, sharing direction and mimicking the movements of the other. The level of this positive correlation can be measured and ranges from a strongly correlated pair to one which can be considered weak or not correlated. Conversely, whilst some pairs can be seen to follow patterns and fluctuations some currency pairs are negatively correlated, meaning that they do almost the precise opposite to each other. It is important to understand these relationships in order to trade multiple currency pairs successfully. Knowing which pairs move together, both positively and negatively, will help in making important decisions when entering more that one position on more than one pair.
Currency pairs do not trade alone and are all interrelated in some way due to the fact that exchange rates are the relative reflection of value between two currencies. These relationships create correlations which are the statistical measure of the strength of the link between the different currency pairs. This ranges from a correlation coefficient of +1 for perfectly positive correlation and -1 for perfectly negative correlation. Currency pairs are never in perfect correlation but exist somewhere in between, but usually significantly closer to one end of the correlation spectrum thus allowing them to be considered negatively or positively related to one another. The importance in understanding which pairs are currently correlating is most obvious for traders who trade across multiple pairs and who look to the correlation coefficient for guidance on the management of their portfolios.
Currency pairs correlation can fluctuate and are not considered static. Global economic changes stimulate variations in the level of correlation between currency pairs. This can be for a number of factors but the most common are the divergences in monetary policy causing currency pairs to either agree with each other or not. Some pairs however, are always considered as largely correlated for most, if not all of the time. For example, the EUR/USD and the USD/CHF have a very strong negative correlation, whilst the EUR/USD and the AUD/USD are often positively correlated. This means that, when the EUR/USD rallies, the AUD will also rally against the dollar. At the same time, the US dollar will fall against the Swiss franc as the correlation between these tow currency pairs is negative. Traders can use the knowledge of these relationships in order to position themselves on the correct side of the market. Therefore, when the Euro begins to rally against the dollar they would have the foresight to make sure that they were not exposed to any short positions against the AUD/USD as this would counteract any profits made due to the positive correlation.
The understanding of currency pair correlations prevents a trader cancelling out two separate trades across multiple currencies. Similarly, if a trader wishes to spread risk and diversify but still maintain an overall directional position in the market, they often will trade two currencies which have a stong correlation but which may not be +1 or -1. This way if a trader wanted to be long on the EUR/USD but did not want to be exposed to just this currency pair it may make sense for them to place half of their risk on a similar trade in the AUD. Due to the fact that they are not perfectly correlated allows for fluctuations to occur in each but the trader can maintain an overall position on anticipating the direction of both of these pairs. Similarly, hedging two positively correlated positions in opposite directions may allow for successful management. If a trader believes that the Euro will fall against the US dollar then the may decide to also take out a smaller long position on the AUD/USD. This way, a trader can mitigate the potential for losses. If the EUR does fall then the smaller position will close out at a loss but if the EUR value rises then the smaller position will eliminate some of the losses.
