Asset Relationships 101 – A Guide to Using Currency Correlations
Becoming a good trader requires a degree of skill in utilizing volatility to one’s advantage. While volatility is a double-edged sword, your knowledge will spell the difference between earning or losing. One of the most common methods is to take advantage of asset relationships.
In CFD Trading, assets are priced in pairs and these relationships dictate how their co-assets behave. This is called Correlations.
Correlations are a measure of how two different assets are related to one another. This relationship is measured using what is called a Correlation Coefficient. The coefficient is a number that denotes whether there is a positive or negative correlation between them. It can be in percent (-100% to 100%) or in decimal (-1.00 to 1.00)form. The higher the value, the more correlated both assets are in a certain direction. Ideally, one should only be looking at 0.75 and up for positively correlated pairs, and -0.75 for negative.
Speaking of direction, positively correlated pairs move in almost the same manner. Let’s take EURUSD and XAUUSD as an example. We used the correlation table found online and found out that the correlation between them (as of writing) is 78.9% on the daily chart. This means that they look 78.9% alike. (See Fig. 1)
(Figure 1 – EURUSD & XAUUSD Daily Chart Comparison)
Negatively correlated pairs, on the other hand, show an opposite movement against the other comparable asset. Let’s take the GBPJPY and the EURAUD as an example. Using the same correlation table gives us a value of -82.6% Correlation. This means that they move in the opposite direction at the rate of 82.6%. Take note that negative numbers denote opposing movements.
(Figure 2 – GBPJPY & EURAUD Daily Chart Comparison)
There are also charts that prove to have poor or no correlation. These charts should not be traded along with the other since the relationship between both assets are indifferent to each other. As an example, take AUDCAD and USDJPY in the chart below. You’ll notice that the trends in both are different and are not moving in completely opposite directions.
(Figure 3 – AUDCAD & USDJPY Daily Chart Comparison)
Tips For Using Correlations
Correlations can be utilized in a variety of forms to incorporate a trading strategy. Here are some tips that we can share to allow you to get the best possible outcomes:
1. Correlations are relative. They change from time to time.
- In using correlations, keep in mind that all relationships (even in real life) are all temporary. Nothing is permanent, and the same goes with correlations. Moreover, having known this, one should make sure that the corresponding correlation value for currency pairs remains high or low. No in-betweens.
2. Correlations can be used as a hedging tool.
- In knowing correlations, one may be able to hedge an existing trade with a highly correlated pair with a delayed (or oftentimes, less volatile) movement. This way, losses can be recovered and the risk of failure is lower.
3. Correlations can be used to supplement existing strategies to open more positions in different pairs – increasing the odds to gain from the market.
- One can multiply one’s income potential just by being mindful of the effects of asset correlations by trading multiple pairs with a confirmed directional bias. This way, one can gain more pips.
4. Correlations can also be used as a leading (or lagging) indicator.
- Volatility has been a trader’s friend. Learning about correlations allows one to identify an asset that is set to move based on correlations. Placing a trade on a slower (less volatile) pair can work wonders too.
In the end, understanding correlations will help you come up with more educated decisions with your trades as this is based on actual and real time data. This feature is very useful for those intending to become fund managers looking to maximize their income potential, lessen risk and provide oneself with a strategy that corners all markets and all sessions. The flexibility to create new avenues for income is a good thing to have.
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