Just wondered how popular this method of trading is in the forex world and whether any of you are/have been successful using it? Trading the EURUSD vs. GBPUSD for example…
Thx
Vitali
While it is great to see correlations between currency pairs, may I suggest that you focus on only one or two pairs at the most. It is easy to say that because EU is going up, then GbpUsd is going up and UsdChf must be going down. If you are right, you are right three times at best. If you are wrong, you are wrong three times. When I started out I found myself doing this and making lots of bad decisions more quickly. You would also have to have the dicipline to only bet 1/3rd of your risk tolerance on each, because you are making one decision and spreading it across 3 bets.
Each pair has a slightly unique rhythm that you will see as you learn it. Where you get into trouble is in the volatility of each of the pairs. The euro is less volatile than the pound, for example; so, a 10 pip drawdown on the euro would knock you out of a potentially good trade on the pound.
Stick with what you know and risk a predetermined amount each time.
Best of Luck
Foricks
One correlation that I have done in the past and find myself doing on a semi-regular basis is of course EUR/USD and GBP/USD. Like, if I think [I]Risk[/I] is [I]bid[/I] rather than [I]offered[/I] quite strongly on the day, I will usually divide my positions between the two, with the balance depending on which has the greatest risk/reward ratio. I find that in most cases, when one is moving up so is the other, but not always, and not at the same speed. It is a good idea to track both if you trade either one, because if there is large divergence, that usually means something big and fundamental is happening to one of the economies. GBP/USD is usually the more volatile of the two, and coincidentally has a greater risk/profit potential in most cases. Actually it’s my favourite pair.
You can also take what you know with these two pairs and apply them (with caution and careful analysis of course) to the crosses EUR/JPY and GBP/JPY.
I think the situation is probably similar with the AUD/USD and NZD/USD and AUD/JPY and NZD/JPY but I haven’t had the time to apply analysis or trade any of these four pairs, but from what I’ve seen, they are potential monster pip generators.
In any case, do your homework before you open your positions, and never get into habbits, i.e. well it worked yesterday so I’m [I]sure[/I] it will work today. This is something that I did for a little while without even thinking about (it worked very nicely btw April and June if you notice the massive run up on the long side for both the pairs. On a daily chart they are very similar), but fortunately I realized this as I was doing it and didn’t suffer any serious damage.
A way to trade correlation is the CAD/JPY, USD/CAD and Crude Oil futures correlation every Wednesday at around 10:30 am EST after EIA Petroleum Status Report release.
This news has an immediate impact on Crude Oil and it’s commodity currency CAD a.k.a. “Loony” and JPY because Japan is a major importer of Crude Oil.
Crude Oil goes up because EIA inventory is lower than forecast…USD goes down…CAD goes up…in the USD/CAD pair.
CAD goes up…JPY goes down…in the CAD/JPY pair.
The opposite if EIA inventory is higher than forecast.
Last week the major USD/CAD move preceded the Crude Oil move up, yesterday.
A word of caution…the Central Bank of Canada is about to intervene because the “Loony” is getting to strong for central bankers taste.
There really isn’t any such thing as “pairs trading” in forex as other markets would term it because technically everything is pairs trading in forex. EUR/USD isn’t like trading IBM. It’s more like trading IBM against DELL.
If you attempt to pair trade EUR/USD vs GBP/USD you’re really just trading EUR/GBP - at least in large part depending on how you size the positions.
For example, say EUR/USD is at 1.40 and GBP/USD is at 1.60. If you go long a lot of EUR/USD and short a lot of GBP/USD what you’ve basically got is a long of $140k worth of EUR/GBP with a $20k leftover short GBP/USD. If you matched the trade values up completely then you’d have a 100% EUR/GBP long.
As usual Rhodytrader makes a great point, and one that many who pursue “trading” forex do not understand. In most cases, it involves trading correlated pairs that result in a synthetic position or cross. A prominent example is EUR/USD and USD/CHF traded to result in a synthetic EUR/CHF position - much like simply trading EUR/CHF! Going long the first and short the second or vice-versa may provide a short-term edge you can exploit, but care has to be taken with adjustment of position sizing to ensure the correlation doesn’t overexpose you to some adverse movement.
A couple of other examples discussed less often that I sometimes trade would be: AUD/USD v. EUR/AUD; GBP/CHF v. EUR/GBP.
Also, there are direct and inverse correlations: generally, the first is a measurement of how tightly pairs move in tandem and the second a measurement of how tightly pairs move in opposite directions (the measurement is called a correlation coefficient, ranging from +100 to -100). There are tools around if interested that can help you evaluate how a selection of pairs are doing on a daily chart v. an hourly chart, etc.
The other kind of “correlation trading” is based on exploiting developments in across instruments, such as Cas’ example of forex vis-a-vis commodities. Pairs involving CAD are impacted by the performance of crude oil, pairs involving AUD and NZD are usually impacted by performance or developments with Gold, etc. Often what happens in one market will have a derivative influence on the other market. There is also heavy interplay between equities (the Dow vis-a-vis GBP/JPY is an example) and bond markets and forex. This general area is known as intermarket analysis and takes some study and observation to become proficient in but is a highly, highly useful ability to include in trading toolkit.
Think of the Butterfly Effect: an initial cause in one market can and will have an effect elsewhere. Most everything in the “financial system” is interconnected. Where that relationship is recognized, observation of the cause usually yields an opportunity to position yourself to benefit from the effect.
EUR/USD v. GBP/USD and that kind of thing is less reliable: correlations between pairs where the counter (second) currency is the same work where monetary policy or some other fundamental development greatly impacts that currency heavily, but responses in the market may differ with the relative strength or weakness of the base currency. So while the EUR may advance dramatically against the USD if NFP surprises big to the upside, GBP may have a mild uptick, hardly move at all or even go down. Usually not, but this kind of “correlation” is more fickle and should be closely monitored.
If GBPUSD goes up then ( usually ) USDCHF goes down.
You can use this to “hedge” or to pick trade direction.
Now that’s a vague statement to make. I would not put my hard earned capital at risk because of the above statement.
As Andrewunknown said…there is cause and effect in the markets.
What causes the GBP to rise…and what [B]might[/B] cause the CHF to rise?
Perhaps it is smarter to trade GBP/CHF instead once you have determined cause and effect.
You can use this to “hedge” or to pick trade direction.
Why would I want to do that?
If GBP/USD is rising then there’s a good chance it’s because of USD selling, which is why USD/CHF falls.
Regardless of what may or may not happen in the future, for the time being the USD is far and away the most dominant currency. That means when something is impacting it there will be repurcussions across all USD pairs. Yes, some will be impacted more than others, but that shows up in the cross rates. If EUR/USD rises more than GBP/USD does it’s because EUR/GBP is rising.
Going long EUR/USD and short USD/CHF just means a double short the USD. The only edge it could provide, if you want to call it one, is that it would ensure that you don’t pick the wrong currency against which the USD will lose the most ground - unless of course it ends up being GBP or JPY, or something else. At the same time, however, it also assures that you won’t pick the one that’s going to do best either. If you are confident of a view on EUR/CHF then you are better off just picking either EUR/USD or USD/CHF, not both.
So, isn’t the idea behind it to hedge against volatility?
E.g., risk appetite bias is upward, long EUR/USD & short GBP/USD.
Less volatility in the EURO provides smoother ride to upside. Volatility in GBP/USD allows profit in the event that an unexpected downside move ensues, albeit temporarily or also in the event of a unforeseen trend change.
Similar to the days of ‘hedging’ platforms allowing you to simultaneously go long & short the same pair with say a 3:1 r/r in both directions.
Before you make claims about this pair being more volatile than that pair, make sure you look at it in terms of pct rather than pips, because that’s how it’s going to play out in your account.
Regardless of which is more or less volatile individually, if you go long the EUR and short the GBP then you are in a long EUR/GBP position. That means you are exposed to that relationship, which has its own dynamic and can move substantially at times.
As for “hedging” with a 3:1 R/R, by definition that is impossible since so long as you’re both long and short the same pair in the same size you can neither make nor lose a single penny. There’s no risk or return. It’s only when one side of the position is taken off (or before you put it on) that you have an R/R situation.
I appreciate the perspective on the percentage view. I look at that every day on my quoteboard, but don’t factor it in enough in hindsight.
I think I may have worded my explanation poorly. I understand the concept of creating the synthetic EUR/GBP position, but doesn’t the ability to close either position with independent stops/targets once market action unfolds increase probability of success, rather than trading the EUR/GBP pair on it’s own?
re: hedging, I assumed stop/target to create the R/R situation. I didn’t state that though. My apologies 
It doesn’t change the odds of success or failure at all because of the required mathematical relationships between EUR/USD, GBP/USD, and EUR/GBP. No matter what one does, the others adjust to account. If you’re creating a synthetic position you’re actually in a negative situation because of the extra transaction costs and the fact that the carry will be less favorable or even more negative.
re: hedging, I assumed stop/target to create the R/R situation. I didn’t state that though. My apologies
You’re talking a grid or straddle type of strategy, but the fact of the matter remains that so long as both a long and a short are on then no profit or loss can be made. If you put on a hedge at 100 and take profits on the long side at 101, it’s exactly the same in P&L terms as just waiting to get short at 101.
thanks John, for your explanation.
So, just trade the cross & be done with it I guess?
And re: hedging (even though it’s n/a anymore w/o mult. platforms,) just take the net of the two ideas & trade that, which will cut transaction costs…?
I think I dig.
It’s apparently not very popular, but I highly recommend trying it and I’ll tell you why. When you’re working with both pairs you are actually only concerned with the price difference between them. That difference will typically run in it’s own range and your mission is to sell the spread when it’s wide and buy when it’s narrow. Now, as you’ve read, trading both pairs together isn’t always the most efficient way to trade it [B]BUT[/B] it is the most understandable. You can [B]VISUALLY[/B] see that the spread is likely in an over-bought or over-sold situation. When you look at a E/G chart it may be a coin toss as to whether it’ll go up or down, but look at the spread between the E/U vs G/U and you just might [B]SEE[/B] the spread is out of wack and will very likely come back into line.
Obviously, things can go against you just like it can trading any method you choose, but (for me) this seems to put things in better perspective and tells me the direction to trade it. If you choose to do both pairs against each other, you’ll see what’s going on. Once you’re very comfortable watching it this way you can go to just trading the single pair if you want.
Personally I’m willing to be a little less efficient and trade both pairs. Try it and see what you think. If it works better…great. If not, hopefully you’ve gained some knowledge for your effort. I’ve done this with both equities and futures contract so it doesn’t seem crazy to me to trade this way. To me, it makes it more interesting. Apparently I’m about the only one who’s brain works this way.
Regarding correlated pairs in case GBPJPY and GBPAUD in daily tf are exactly the same but the what happens in gbpaud is reflected in gbpjpy hours after (up to 4 hours), you can use this for your advantage.
Hello Rhody !
I am a newbie here on this forum and this being my first post. I am very much impressed by your post to which I am replying. You said if we go long a lot on EUR/USD and short USD/CHF. I understand this part. But when you say:
“If you matched the trade values up completely then you’d have a 100% EUR/GBP long”, I really don’t understand this. Can you please explain ? 
Secondly, let’s suppose we go long EUR / USD and short USD / CHF (which is effectively EUR/CHF and much like simple EUR/CHF), what rates there should be and position sizes to offset each position so our net position will be zero?
I don’t know this just popped in my mind, so I asked you
Third question, let’s suppose we just long EUR/USD in main account (ONADA) and short EUR/USD in subaccount. Can you please explain the intricacies or implications or benefit of this type of trade?
Your kind reply is much appreciated. Thanks!
Outside of looking for an advantage on trading crosses/synthetics, as most of the above contributors have noted (sound posts all, I might add), another way to use correlation of pairs is to follow the general trends of the majors to find one or two lagging pairs and find an appropriate entry in them as they attempt to “catch up” with the others.
EUR/USD, GBP/USD, AUD/USD, NZD/USD and EUR/JPY all tend to move in the same general directions most times. USD/CAD and USD/CHF generally move opposite. USD is the most heavily traded currency (67% of all trades involve USD, if I am not mistaken) so it stands to reason since the strength/weakness of USD is actually being traded. JPY acts as a USD proxy in the case of the EUR/JPY for odd macro-factors I never quite understood.
If you bring up the charts you will see they all have the same general shape. They all make similar swing highs and swing lows, some go much further or much less depending on the strength/weakness of the currency opposite the USD, but they nearly all make their swings at approximately the same time.
If the EUR, GBP, AUD and NZD and CHF against the USD are all turning at what appears to be a swing point but CAD and EUR/JPY are not…Pay close attention!
They are most likely lagging a bit behind and a decent entry can be found to enter a trade near an exact top or bottom. It doesn’t always work out so neatly but it does more often than not. If you see a very nice, large pin bar at a support or resistance level on one of these pairs, for example, check the other correlated pairs. You will most likely find that several have a nice, large pin forming at the exact same time. For those that do not, you may notice they have already turned and are heading in the opposite direction. The other(s) that have not formed a pin or have not reversed may be lagging and be about to change. Prepare to jump in.
I have found the one hour and 15 minute time frames highlight these correlated reversals best. PurplePatch’s Cat and Mouse strategy is a very short, very, very, very small profit strategy that uses pair correlations for quick scalps. The same general principle, however, applies: correlated pairs move together (I know, I am stating the absurdly obvious here).
When stock scalping years ago I would usually use market and industry indexes the same way. If the major market indexes are rising and the financial industry indexes are rising and a few regional banks are not… jump in… they are about to. They are simply lagging their peers. To apply those lessons to Forex, if all USD pairs are suddenly rising but NZD and EUR are not… they usually will. You have a heads up of knowing where to, at the very least, look for an opportunity by using the above mentioned pairs as an industry index, if you will.
If one or more of the pairs haven’t been correlating in the last week or two, ignore them and focus on the ones that have been correlating. If no clear entry signal can be found (through whatever strategy you typically employ), pass the trade. After all, just because they are correlated doesn’t mean they HAVE to move together but they generally tend to.
Just another interpretation of correlation I thought I would throw out there.