How do currencies move in relation to each other?
The following is our
monthly correlations update for November. As we have previously
mentioned, correlations between different currency pairs shift over time,
therefore it is of utmost importance to regularly follow changes in correlation.
We have also included the 3 month and 1 year correlations to give traders a
better sense of historical trends and added 6 month trailing correlations as
further confirmation of the correlation results.
In order to be an effective trader, it is also
important to understand how different currency pairs move in relation to each
other. There are a few reasons why this is significant, but most importantly, it
allows traders to understand their exposure. That is, having a portfolio that
consists of the EURUSD and GBPUSD is different from having a portfolio that
consists of the EURUSD and USDCHF. As indicated in the tables below, over the
past year, the EURUSD has had a strong positive correlation (+0.96) with the
GBPUSD and a strongly negative correlation with USDCHF (-0.99).
Therefore having a long EURUSD and long USDCHF
exposure would generally lead to negated or nearly zero profit or losses because
when the EURUSD rallies, USDCHF will sell off the majority of the time. Of
course, these two currencies have different pip values, so the P/L may not be
exactly zero. On the other hand, holding long EURUSD and long GBPUSD exposure is
similar to doubling up on the position since the correlation is so strong.
Furthermore, we can tell from our tables that
correlations shift with time. The GBPUSD and NZDUSD have a relatively strong
positive correlation (0.83). This relationship broke down quite a bit this month
however as we see a one month correlation of (0.14). Having this knowledge will
allow traders to effectively diversify and manage their portfolios. Shifts such
as these can be partially explained by changes in the severity of monetary
policy or changes in unique domestic conditions.
Regardless of your trading strategy and whether
you are looking to diversify your positions or find alternate pairs to leverage
your view, it is very important to keep in mind the correlation between various
currency pairs and their shifting trends.
Kathy Lien
Kathy Lien is the Chief Currency Strategist at
Forex Capital Markets. Kathy is responsible for providing research and analysis
for DailyFX, including technical and fundamental research reports, market
commentaries and trading strategies. A seasoned FX analyst and trader, prior to
joining FXCM, Kathy was an Associate at JPMorgan Chase where she worked in Cross
Markets and Foreign Exchange Trading.
Kathy has vast experience within the interbank market using both technical and fundamental analysis to trade FX spot
and options. She also has experience trading a number of products outside of FX,
including interest rate derivatives, bonds, equities, and futures. She has a
Bachelors degree in Finance from New York University. Kathy has written for
Stocks and Commodities, CBS Market Watch, ActiveTrader, Futures and SFO
Magazine. She is frequently quoted on Bloomberg and Reuters and has taught
seminars across the country. She has also hosted trader chats on EliteTrader,
eSignal, and FXStreet, sharing her expertise in both technical and fundamental
analysis.