This tool should be on every forex trader’s desk…
The following is our monthly correlations update
for August. 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 EUR/USD and GBP/USD
is different from having a portfolio that consists of the EUR/USD and USD/CHF.
As indicated in the tables below, over the past
year, the EUR/USD has had a strong positive correlation (+0.94) with the GBP/USD
and a strongly negative correlation with USD/CHF (-0.98). Therefore having a
long EUR/USD and long USD/CHF exposure would generally lead to negated or nearly
zero profit or losses because when the EUR/USD rallies, USD/CHF 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
EUR/USD and long GBP/USD 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. Although the USD/JPY and EUR/USD usually have
a strong negative correlation (-0.90), this relationship broke down quite a bit
recently as evidenced by the weakness in the one month correlation (-0.19).
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.
FX Correlations (data as of 08/31/05)
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.