What is Correlation in Trading?

Correlation defines the relationship between the price movements of two or more assets and measures how they respond to each other. Traders can maximize their returns by considering correlations when building portfolios or developing trading strategies.

Correlation typically ranges from -1 to +1. Positive correlation (between 0 and +1) indicates that the prices of two assets generally move in the same direction. For example, if there is a positive correlation between the prices of two stocks, when one rises, the other tends to rise as well.

Negative correlation (between -1 and 0), on the other hand, indicates that assets generally move in opposite directions. When one asset rises, the other may decline.

It's is a great aid for traders in diversifying their portfolios. If an investor selects instruments with low or negative correlation within their portfolio, they can reduce the risk. This is because when the value of one asset decreases, the negatively correlated asset may rise, offsetting the loss.

In our article, you will find detailed information on the use of correlation in trading.

What Correlation Can Tell You?

Correlation helps traders understand how the price movements of assets are related and what kind of impact these relationships can have on the market. Knowing whether there is a positive, negative, or zero correlation between two assets offers investors a deeper understanding of market dynamics and potential opportunities.

The key insights that correlation offers traders are as follows:

• It can provide an idea about the overall direction of the market. For example, if there is a high positive correlation between stocks in a particular sector, it can be understood that the sector is experiencing an overall upward or downward trend. Assets within the same sector may exhibit similar price movements as they are influenced by the same external factors.
• Traders can protect themselves from market fluctuations by selecting instruments in their portfolios that have low or negative correlations with each other.
• Understanding the relationships between different asset classes allows traders to create combinations of assets that can benefit from different market conditions at the same time, helping them diversify their portfolios.
• Correlations can also be used for short-term trading strategies. If there is a positive correlation between two assets and one is rising while the other lags behind, traders can take advantage of this gap.

How to Calculate Correlation?

The Pearson Correlation Coefficient is typically used to measure how two variables respond to each other. This coefficient expresses the relationship between two assets with a value ranging from -1 to +1.

The steps to calculate correlation are as follows:

• The first step is to gather historical price data for the assets to be analyzed. This data is usually based on closing prices and compared over a specific time period.
• To compare the price changes of the two assets, the daily or weekly returns for each asset are calculated. This requires finding the percentage change in prices for each period.
• The return calculation is done using the following formula

This formula calculates the covariance between two assets, dividing it by the standard deviation of each asset to determine the correlation. The result will be a value between -1 and +1.

Types Of Correlation

• Positive Correlation: This indicates that the price movements of two assets are in the same direction. In other words, when the price of one asset rises, the price of the other asset tends to rise as well. Positive correlation ranges between 0 and +1. To give an example, two stocks in the same sector may have a positive correlation.
• Negative Correlation: This indicates that the prices of two assets move in opposite directions. When the price of one asset rises, the price of the other asset tends to fall. Negative correlation ranges between -1 and 0. For example, there is often a negative correlation between gold prices and stock prices; when one rises, the other may fall.
• Zero Correlation: Zero correlation means that there is no relationship between two assets. In other words, when the price of one asset changes, it has no significant effect on the price of the other asset. If the correlation coefficient is close to 0, it can be said that there is no meaningful relationship between the assets.

Example of Correlation

Let's start with an example from Forex. A well-known example is that EUR/USD and GBP/USD pairs generally have a high positive correlation. This is because both pairs are traded against the U.S. dollar, and the Euro and British pound are connected to European markets.

These two pairs typically move in a similar way. For instance, during a period when the U.S. dollar weakens, both EUR/USD and GBP/USD tend to rise.

Gold and crude oil, on the other hand, can be shown as two commodities that have a negative correlation. These two assets react differently to various economic conditions and risk factors.

For example, in times of economic uncertainty, traders turn to gold, and gold prices rise. However, during the same period, with a decrease in global demand, oil prices may start to decline. In this case, we can say that there is a negative correlation between gold and oil.

Correlation Of Forex Currency Pairs

Correlation coefficients determine how closely the price movements of two currency pairs are related, and this relationship can be either positive or negative. For example, there is a 77% high positive correlation between the EUR/USD and GBP/USD pairs. This means that when the Euro/Dollar pair rises, there is a 77% probability that the Pound/Dollar pair will also move in the same direction.

Similarly, the EUR/USD pair has a strong negative correlation of -79% with the USD/CAD pair, indicating that these two pairs generally move in opposite directions.

Additionally, there is a strong positive correlation of 88% between the GBP/USD and GBP/JPY pairs. Since the first currency in both pairs is the British pound, this high correlation can be attributed to the movements of the US dollar and the Japanese yen.

EUR/USD Correlation Table

GBP/USD Correlation Table

AUD/USD Correlation Table

How to Use Correlations to Trade Forex?

• Currency pairs with positive correlation move in the same direction, allowing you to manage your positions more efficiently by investing in one of these pairs.
• With negatively correlated currency pairs, you can diversify your portfolio and help balance your risk.
• Currency pairs with high positive correlation can be risky because they are exposed to the same market movements. For example, if there is a high positive correlation between EUR/USD and GBP/USD pairs, taking positions in both can increase potential losses as they move in the same direction.
• Correlations can be effective in identifying market opportunities. For instance, if the correlation between two positively correlated currency pairs weakens over time and one pair rises while the other lags behind, you can take advantage of this difference by seeking opportunities in the lagging pair.
• For short-term trades, you can examine daily or hourly correlations to find quick opportunities.
• In long-term strategies, you can analyze monthly and yearly correlations to create positions over a broader time frame.

Populer Correlation Strategies in Trading

Pair Trading

It is a strategy based on trading between two assets with positive or negative correlation. In the case of positive correlation, traders try to take advantage of market movements by buying one asset and selling the other.

In negative correlation, opposite positions are taken to aim for profit. This strategy seeks to capitalize on market imbalances by leveraging the variability of correlations.

Portfolio Diversification

One of the most common uses of correlation strategies is to diversify an investment portfolio. Investors combine assets with low or negative correlation to spread risk.

Correlation Divergence

This strategy targets investment opportunities that arise from changes in asset correlations. When a positive correlation between two assets weakens and one outperforms the other, traders can potentially exploit this divergence. Likewise, opportunities may exist when a negative correlation is disrupted. Similarly, opportunities may arise when a negative correlation breaks down.

FAQs About Correlation in Currency Trading

Which currencies are the most correlated?

Some of the most correlated currencies include pairs like EUR/USD and GBP/USD, which tend to have a high positive correlation due to both being traded against the U.S. dollar. Additionally, AUD/USD and NZD/USD often move together, reflecting similar economic influences from their respective countries. On the negative side, pairs like USD/CAD and EUR/USD typically show a strong negative correlation.

What are positive and negative currency correlations?

Positive currency correlations occur when two currency pairs move in the same direction. For example, if EUR/USD and GBP/USD have a positive correlation, when one rises, the other is likely to rise as well. Negative currency correlations mean the pairs move in opposite directions. For example, when EUR/USD rises, USD/JPY might fall, showing a negative correlation between them.

What is the difference between correlation and covariance?

Correlation and covariance both measure how two variables respond to each other. Covariance expresses how two variables move together in general and can be either positive or negative. However, correlation normalizes covariance to measure the strength of this relationship. While the correlation coefficient ranges from -1 to +1, covariance can have an unlimited value.

How reliable are correlation signals?

Correlation signals are generally reliable but can change over time depending on market conditions. The correlation between a currency pair can weaken or strengthen based on factors such as economic developments, central bank policies, or geopolitical events.

How can correlation analysis be combined with technical analysis?

When combined with technical analysis, correlation analysis can create stronger trading strategies. Technical analysis generates trade signals by examining chart patterns, support/resistance levels, and trends. Correlation analysis helps understand the relationship between one currency pair and another. When these two analyses are used together, you can make more reliable trading decisions by evaluating both price movements and their relationship to other assets.

Is there a correlation between commodity markets and forex markets?

Yes, there can be a correlation between commodity markets and forex markets. For example, the Canadian dollar (CAD) often has a positive correlation with oil prices, as Canada is a major oil producer. Similarly, the Australian dollar (AUD) is linked to natural resources like iron ore.