Improve your forex trading with currency correlations

WHEN quantitative easing was introduced earlier this year, there was no doubt that it would shake up the markets. But a race to zero interest rates and the adoption of QE by many of the G10 countries has meant that foreign exchange traders have had to adjust their strategies to this new market environment.<br /><br />Continued volatility in the currency markets has meant that it is more important than ever for traders to manage their exposure and understand the sensitivity of their portfolios. Because currencies are priced in pairs, no single pair trades completely independently of the others. So one highly useful tool when deciding which currency pairs to trade and the profile of your portfolio is currency correlations.<br /><br />A correlation of +1 means that the currency pairs will move together 100 per cent of the time, while a correlation of -1 indicates that the pairs will move in the opposite direction all of the time. A correlation of zero implies that the relationship between the currency pairs is completely random. The correlations in the table are shown as varying between -100 and +100.<br /><br />Forex traders can use currency correlations in three ways: choosing positions carefully, hedging most effectively and diversifying their portfolio.<br /><br />By looking at the currency correlations, traders can avoid choosing to enter trades in pairs that effectively cancel each other out. For example, when euro-dollar tends to rise, the dollar-Swiss franc sells off. This pair has a very negative correlation of -89.4 and is shown by the graph on the right &ndash; having long positions in both pairs would be the equivalent of having an almost neutral position. On the other hand, euro-US dollar and Australian dollar-US dollar have a positive correlation of 85.5, so going long on both pairs is similar to doubling up on the same position.<br /><br />However, currency correlations can help you hedge your positions better. By choosing very negatively correlated pairs you can maximise your chances of minimising potential losses in the case that your view is proved wrong by the markets.<br /><br /><strong>DIVERSIFIED PORTFOLIO<br /></strong>You can also use the correlations to diversify your portfolio of currencies traded. If you have a central directional view then it can be highly risky to double up your position on one pair as currency-specific events may derail the trend. By going long on two positively correlated pairs you can diversify your portfolio and slightly lower your risk exposure.<br /><br />Currency correlations are undoubtedly very useful to traders but they can change for a multitude of reasons, not least quantitative easing, other central bank policies and changes in sentiment &ndash; note for example the growing importance of risk appetite.<br /><br />Political or monetary policies, such as the central banks&rsquo; different stances on quantitative easing, mean that the negative relationship between euro-dollar and dollar-Swiss franc can break down to an extent.<br /><br />The Swiss franc, which had moved in line with other safe havens like the US dollar and the Japanese yen, no longer does so to the same extent. Intervention by the Swiss National Bank is effecting a decoupling of the Swiss franc from the other safe haven currencies.<br /><br />Equally, BNP Paribas currency strategists note that since the introduction of quantitative easing the Japanese yen has broken existing correlations. For example, both the yen and sterling have strengthened at the same time in recent days. It used to be the case that the two currencies usually moved in opposite directions, but sterling finally seems to be doing its own thing, says John Hardy, FX consultant at Saxo Bank.<br /><br /><strong>SHIFTING CORRELATIONS<br /></strong>It is too early to tell whether these decouplings are temporary or permanent, but it is important to keep an eye on the shift in correlations to make the most of new opportunities arising and move out of positions that are no longer effective.<br /><br />However, for day traders their use is more limited as correlations are very fragile and can break down quickly in the short-term. They can even go into reverse if fundamentals or newsflow prove an overriding driver, so traders should always be aware of economic developments that are likely to affect their currency pairs.<br /><br />Like any good trading technique, currency correlations are best used in context. But there is no doubt that they are a highly effective means of determining the compilation of your portfolio and can maximise your chances of making a profit. Ignoring them is to risk making avoidable mistakes in an unforgiving market.