Financial markets or financial products are interconnected and correlations can be found between different products. These correlations need to be known in advance, otherwise, they will lead to overtrading the account.
Overtrading, in turn, leads to heavy losses and to the trading account not respecting the money management system anymore. To avoid that, traders must focus on multiple markets and to correctly interpret the economic news that influences a trade and the decision to trade or not a financial instrument.
Correlations can be found between different currency pairs, but also between currency pairs and other markets, like indices, commodities, etc. It is important to know what triggers them, what are the implications and what to do to avoid any wrong-doing in the trading account.
It all starts with the U.S. dollar. The dollar is the world’s reserve currency and it is the pillar the financial system is built on.
It is not clear if this is a burden or a privilege for the U.S. economy, but this is a subject for a different topic. Everything in this world is influenced by the dollar and transactions across the globe are cleared in dollars.
This is being seen in the Forex dashboard as well. All the currency pairs that have the U.S. dollar in their componence, are called major pairs.
The other ones are crosses. Below there are a few crosses shown and most of the major pairs offered by a Forex broker.
Correlated trades are happening when multiple dollar pairs are traded in the same direction before/during a U.S. dollar driven event. Let me give you an example!
Suppose the Non-Farm Payrolls (one of the most important pieces of economic data from the United States) is released at the end of a trading week. This is a U.S. dollar driven event.
If one is bullish the EURUSD pair and buys it, it is not wise to buy the GBPUSD as well, for example. Chances are that both pairs will move in a directly correlated fashion because of the U.S dollar.
It is like taking two trades on the EURUSD pair! This is overtrading and buying AUDUSD, NZDUSD, or selling USDCAD or USDJPY is the same thing like taking another position on the EURUSD pair.
Risk-On vs. Risk-Off
These correlations led to a new terminology to be used: the risk-on and risk-off environments. They are the perfect illustrations of how correlated products are interpreted.
A risk-on environment calls for EURUSD, GBPUSD, AUDUSD, and NZDUSD to rise, while the USDCHF, USDJPY, and USDCAD to fall. A risk-off calls for the opposite to happen: the EURUSD, GBPUSD, AUDUSD and NZDUSD fall, while the USDCHF, USDJPY, and USDCAD rise.
When either of the two situations is happening, taking more trades on different currency pairs will be the equivalent of taking them on one pair only. As you can see, they are all U.S dollar denominated pairs.
This is one of the strongest correlations to be found. The Canadian Dollar (CAD) shows a strong direct correlation with the oil market.
It is so because the Canadian GDP (Gross Domestic Product) is dependent on the oil market. The oil industry makes a big chunk of the Canadian economy.
Therefore, whatever happens with the oil price will influence the value of the Canadian currency, the CAD. When it comes to the Forex market, the oil price and the USDCAD pair enjoy an inverse correlation: when oil is falling the USDCAD is rising, and when the oil price is rising, the USDCAD pair is falling.
This is important to know when trading the USDCAD pair and any other CAD denominated currency pair. Economic news like oil inventory levels in the United States, OPEC (Organization of Petroleum Exporting Countries) meetings, and other oil related information matters for the Canadian dollar.
Gold is viewed by many as a currency. It is not a currency, but it serves for many purposes and it is acting like a currency in many ways.
The Australian economy is a commodity driven one. Coal, gold, iron and many other commodities make the most of the Australian exports and, hence, they are influencing the GDP.
This means the Australian dollar (AUD) is influenced as well, and this is being seen on the AUDUSD pair and other denominated AUD pairs, like GBPAUD, EURAUD, etc. It is difficult for the Australian dollar overall to lose value when the gold market is in a bullish trend, for example.
The USDJPY is strongly correlated, in a direct fashion, with the U.S equity markets. This is not happening all the time, but it is difficult to sell the USDJPY pair and at the same time to buy, say, the Dow Jones index.
In the past, this correlation was so strong that for every USDJPY pip advance or decline, the Dow Jones made a two-point advance or decline as well. This correlation is not that strong anymore, but it exists and should be considered.
The best example of how correlations work is to consider the currency pairs like a threesome: two majors and one cross. For every major currency pair, there are two cross pairs.
Having said that, it means one knows how a currency pair is moving if there is an analysis on the other two. Let me give you an example!
Suppose the EURUSD is bullish and, per the technical analysis, it should rise by 1% until the end of the trading week. At the same time, the USDJPY is bullish as well, being on an important support level on the bigger time frames and consolidation around that level is expected, and maybe also bounces.
If this is the case, the best trade to be taken is to buy the EURJPY cross. This can be done even without looking at a chart because it will rise based on the difference between the two major currency pairs it represents.
