Forex Trading: Navigating Dynamic Market Correlations

Ever observed that when one currency pair ascends, another descends? Or witnessed multiple currency pairs decline in unison? This phenomenon is termed as 'correlation.' It signifies the strength of the relationship between two variables. 

When these variables share a positive correlation, their movements are parallel. Conversely, a negative correlation implies they move in contrasting directions. 

In the financial trading sphere, especially at ACY Securities, understanding asset correlation is pivotal. It assists traders in predicting the timing and direction of price shifts across various assets. Furthermore, leveraging these correlations can unveil high-probability trading opportunities within the forex market. 

It's imperative to note given that currencies are invariably traded in pairs, no single currency pair operates in isolation. Hence, for adept portfolio and risk management, grasping the interrelations between currency pairs is indispensable when trading with ACY Securities. 

Correlation Coefficient Explained 

The correlation coefficient is a value ranging between +1 (or 100%) and -1 (or -100%), measuring the extent of association between two markets: 

• A value of 1 signifies a 100% positive correlation.
• A coefficient of -1 indicates a perfect negative association.
• A value of zero implies that the movements of the two currency pairs are random, bearing no relation to each other.

Deciphering the Correlation Chart 

Consider the EUR/USD correlation chart presented. Here, you'll notice various shades: 

• Blue Shades: Indicate a positive correlation.
• Red Shades: Represent a negative correlation.
• Grey Blocks: Denote different currency pairs.
• White Blocks: Symbolise neutral correlation.

The intensity of the colours on the chart conveys specific insights: 

• Deep Blue: Implies a strong positive correlation between pairs.
• Vivid Red: Indicates a pronounced negative correlation between pairs.

With ACY Securities, understanding these correlations becomes pivotal, aiding traders in making informed decisions in the dynamic forex landscape. 

Interplay Amongst Major Currencies: Understanding Correlations 

The relationship between EUR/USD and GBP/USD is predominantly positive. Approximately 70% (+0.70) of the time, the daily movements of these two pairs run parallel, as showcased in Figure 1 (with EUR/USD represented in blue and GBP/USD in black). 

This interconnected movement between the two markets is largely influenced by the dynamics of the dollar. Additionally, the roles of both the euro and the British Pound as leading reserve currencies on the global stage cannot be overlooked. 

On the flip side, if we consider the EUR/USD and USD/CHF pairs (refer to the chart above, figure 2 - EUR/USD in blue, USD/CHF in black), there is a striking negative correlation. The USD component is responsible for this nearly 90% inverse relationship in their daily movements. 

At ACY Securities, understanding such intricate market correlations aids traders in crafting informed strategies and tailoring their approaches in alignment with these currency dynamics. Open an ACY Securities account or delve deeper into Trading CFDs with ACY Securities. 

Evolving Currency Correlations: Why and How They Shift 

It is essential to recognise that correlations are not static; they evolve. This dynamism in correlations stems from daily shifts in global sentiment and the overarching economic landscape. A robust correlation is evident between currency pairs today but may not necessarily persist in the long run. Hence, evaluating the correlation over a span of six months becomes pivotal. 

This broader temporal view allows traders to comprehend the average interplay between two currency pairs in half a year. Factors instigating these shifts in correlations include diverging monetary policies, a currency pair's sensitivity to commodity price oscillations, and unique economic and political events. 

Unravelling Intermarket Correlations in Forex 

Forex price trends are fundamentally steered by market sentiment. However, to decipher daily price influencers, it is beneficial to delve into intermarket correlations. Leveraging these correlations, traders at ACY Securities can: 

• Grasp daily market nuances.
• Gauge the intensity of specific market shifts.
• Sidestep events that might jeopardise parallel deposits.
• Evade situations where congruent ventures might face risk exposure.
• Illuminate market movements that could potentially mislead uninformed traders.

The US Dollar Index 

The DXY Index monitors the value of the US dollar by contrasting it with a basket of six major global currencies. The European Union's single currency (EUR) holds the most significant weight in the index, nearly 58%, followed by the Japanese yen (JPY) at 14% and the British Pound (GBP) at 12%. 
 

Given the prominence of the euro, the EUR/USD pair often exhibits movement inverse to the US dollar index. When the DXY indicates oversold conditions, hinting at a potential US dollar rally, it might be prudent to consider selling EUR/USD. Conversely, an overbought DXY often signals a buying opportunity for EUR/USD. 

The techniques traders employ to determine overbought and oversold conditions vary. While some may rely on price action, like support and resistance levels, others might gravitate towards momentum oscillators, such as the relative strength index (RSI). 

The inverse correlation between the US Dollar Index (depicted in blue) and the EUR/USD (shown in orange) can be observed in the figure below. 

Commodity-Forex Pair Correlations: A Deeper Dive 

While many traders primarily focus on the relationships between different forex pairs, it is essential to recognise that commodities exhibit significant correlations with certain currency pairs. Let us take a closer look: 

Oil and the Canadian Dollar (CAD) 

The Canadian dollar's value often mirrors the movement in crude oil prices. For instance, as the oil price climbs, the Canadian dollar usually strengthens on the forex market. Crude oil prices are quoted in US dollars.  

Consequently, shifts in the US dollar's value can substantially affect oil prices. A strong US dollar typically suppresses oil prices, while a weakening US dollar can boost them. In essence, an uptick in oil prices frequently coincides with a declining US dollar value. 

Gold and the Australian Dollar (AUD) 

There exists a positive correlation between gold prices and the Australian dollar, especially observable in the AUD/USD pair. As Australia is a significant gold exporter, the AUD/USD pair often responds directly to gold's price movements.  

When gold prices surge, the AUD/USD generally appreciates, and conversely, a drop in gold prices often leads to a depreciation in the AUD/USD.  

Emerging Market Correlations to Watch 

There is a myriad of traditional correlations that seasoned traders are aware of, but as global economies evolve and intertwine, new and intriguing correlations are emerging. Some of these lesser-discussed but increasingly significant correlations include: 

China's GDP and AUD/USD Correlation 

China's economic growth, especially after the 2008 Great Recession, has positioned it as an instrumental force in global economic recovery. As the CNY (Chinese Yuan) is not a freely floating currency yet, traders sought a liquid proxy that mirrors the health of China's economy. Enter the Australian dollar (AUD). 

Geographical proximity and China's status as Australia's primary trading partner make the AUD highly reactive to shifts in China's economic climate. It is noteworthy that major Australian mining firms heavily depend on exports to China and emerging economies like India. 

New Zealand Dollar and Global Dairy Industry 

The New Zealand dollar (NZD), similar to AUD and CAD, is considered a commodity currency. New Zealand's prowess in dairy production, including cheese, butter, and milk, contributes to over 20% of its exports. Consequently, when global dairy prices surge, the NZD often strengthens relative to other currencies. 

Risk Currencies and Their Correlation with Global Stocks 

There is a noteworthy correlation between risk currencies and global equities, especially prominent with the AUD/USD and NZD/USD pairs in relation to the S&P 500 - a market-cap-weighted index of 500 top-tier US companies. 

The AUD and NZD typically appreciate when there is a buoyant risk sentiment in the global markets. However, a dampening of this sentiment can exert downward pressure on these currencies. 

 These evolving correlations offer ACY Securities' traders fresh perspectives and strategic opportunities, ensuring they stay ahead in the dynamic world of forex trading. 

The New Zealand and Australian dollars tend to rise when optimistic risk sentiment is present. However, a decline in sentiment can put pressure on the currencies, as mentioned earlier. 

Leveraging Forex Correlations in Trading 

Harness insights from forex currency correlations to shape strong trading strategies. Instead of narrowing their focus, savvy traders often diversify across several markets that share positive correlations. 

Example: An optimistic stance on the US dollar might lead to diversifying our chases, like buying USDJPY while exploring other markets correlated favourably to the US dollar. 

• Mitigating Risks with EUR/USD and AUD/USD:
  • Traders can purchase one lot each of AUD/USD and EUR/USD as opposed to two lots of just EUR/USD, signalling a bearish stance on the USD.
  • This strategy can be beneficial given the pairs' sometimes erratic correlations and factors like varying central bank policies.
• Managing Overexposure: Aim to maintain low or non-existent correlation among trading account positions to avert undue exposure to synchronously moving currency pairs.
• Leveraging Pip or Point Values:

Example: In EUR/USD, a pip change for a 100,000-unit lot is valued at $10. The same pip change in USD/CHF is worth $9.24. Due to their strong negative correlation, traders might consider USD/CHF as a hedge against EUR/USD. 

Hedging in Action 

• Scenario Analysis: A trader with a short EUR/USD lot (100,000 units) and a similar short USD/CHF lot could witness a $100 loss if EUR/USD climbs by 10 pips. However, USD/CHF's tendency to move counter to EUR/USD might offset some of this loss.
• Balancing Positions: Skilled traders may strike a balance where a long position on one currency pair is offset by a short stance on another, especially if they are negatively correlated.
• A Word of Caution: Correlations are dynamic. It is pivotal to prioritise risk management and stay abreast with the evolving correlations between currency pairs.

Bottom Line 

A comprehensive understanding of correlations between currency pairs and their influence on other asset classes is instrumental to your forex trading journey. Whether you are diversifying or leveraging your stance using different pairs, maintaining a grasp on currency pair correlations and their evolving trends is crucial. 

Whether you are just starting out or looking to enhance your trading techniques, ACY Securities stands ready to support your journey. Ready to unlock the full potential of futures trading? Get started with ACY Securities today or dive deeper into futures trading with our expert guides. Explore ACY Securities' educational content and expert-led webinars to help traders navigate the world of CFDs and the forex market. Learn more about Indices, Gold, Oil and other tradable instruments we have on offer at ACY Securities.   

You can also explore our MetaTrader 4 and MetaTrader 5 trading platforms including access to our free MetaTrader scripts. Then try out your own trading strategies on your own free demo trading account.