Learning the relationship between forex pairs is extremely important for forex traders. As currencies are traded in pairs, the pairs cannot possibly act in isolation. They behave in relation to each other and developing a clear understanding of how pairs move in forex is crucial for investors.
Correlation among forex pairs means if one pair moves then in which direction the other pair moves, i.e. same, opposite, or random. If two currency pairs move in the same direction then they seem to have a positive correlation, for example, EUR/USD and GBP/USD have a strong positive correlation, they always move in the same direction, if one starts to rise the other one will follow the same. Two currency pairs are considered to have a negative correlation if they move in opposite directions in relation to each other for example, EUR/USD and EUR/CAD have a strong negative correlation if one moves in an upward direction the other will move in the downward direction.
Furthermore, currency pairs that move in random directions in relation to each other mean they have no or zero correlation. There are many reasons why correlation is important in forex such as:
- It will help you avoid canceling positions with pairs. If you are dealing with two pairs that always move in opposite directions and you open the same positions for them for example a buying position, it will be a waste of time and money because when the prices will move one pair will go up and the other down. You will face loss in one trade.
- It is said to have a diversified portfolio in trading so that you do not expose yourself to huge risks. When you deal with more than one pair you need to understand how all of your currency pairs will act in relation to each other and reduce the risk of facing losses and increasing profits.
- You can also use correlation to confirm trends in price movements and avoid fakeouts. If you have five pairs, and with one currency pair, two of which have a positive correlation and two have a negative correlation, during breakouts in price movements you can confirm if it is real or not by monitoring the movements of all your other pairs. If they move as they should, which is two moves in the same direction and the other two in the opposite direction, then you can be sure of the trend and make better trades. Similarly, you can avoid fakeouts if other pairs do not move according to their correlations hence not confirming the trend.
It could be easily concluded that having a good understanding of forex pairs correlations can help you trade better by having good risk management strategies based on your currency pairs correlation.