Trading CFDs carries considerable risk of capital loss. CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74-89% of retail investor accounts lose money when trading CFDs. You should consider whether you can afford to take the high risk of losing your money.

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The importance of correlation in forex trading

When you decide to start your trading on the forex market, you really have to understand the meaning of currency correlations. The main reason is to avoid the opening of two positions with a high positive correlation, i.e. two pairs of currencies, that will move in the same direction, whether they are winning or losing. This means increasing the risk because probably our choices will not always be correct.

Money management techniques are also based on the benefit of diversification, that is to say that your own investment is headed towards assets that do not have the so-called correlation 1. Therefore the trader will have to wisely use the correlation as a tool to reduce the risk while trying to open a trade on currencies with correlation levels not exceeding 0.5 (or less than -0.5, depending on the cross).

A classic example of currencies moving in symbiosis is EurUsd and UsdChf. The opening of two identical positions (long or short against Dollar) on these currencies will give you a big advantage in the event of a winning choice, but you will risk burning a good portion of your capital if your choice becomes loser.

Another example of a “toxic” correlation is related to emerging currencies. Usually Try, Rub, Brl, Zar move in the same direction and when the market faces financial tensions, then this direction is certainly not a positive one.

Carry traders try to go long on high yield currencies and short on those with low interest rates, knowing the correlation very well. Let’s think of the risk that you could run going long on AudUsd and NzdUsd at a time when commodity prices collapse as in January 2016. You would get double currency losses, a useless risk.

Let's now return to the correlation between currencies. The table here below shows us as a pure example of the 1-month correlation between some of the major world currencies (an unexploited exemplification table for trading since it comes from 2015).

forex correlation

If you decide to go long on EurUsd and EurCad, whose correlation is 0.67, you will have similar results for both trades. If EurUsd rises, EurCad also rises, but in either case if you decide to go long on Euro, you will have the same losing results and Cad and Usd will strengthen on the Euro.

A good option might be to go long on EurUsd and simultaneously short on UsdJpy (here the correlation is close to zero).

It would still be better to go long on EurUsd and long on EurPln, due to the negative correlation of -0.3 in that date between the two pairs of currencies.

This correlation mechanism will allow traders to better manage their order book by reducing the risks. Above all, you will not find any unnecessary risk simply because you ignored this basic concept.

Traders often focus only on speculative aspects, charts, leverage, but sometimes, apparently less important details can affect the success of a strategy studied in detail. Correlations are included in this last category.

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