A Question on Correlation

[metin]

Hello Traders,

I have a question on the correlation of currencies. As is known, currency pairs are all correlated yet there’s no sharp rule like if USD is down, all other pairs go up. Because not each of them is affected by big news releases to the same extent and what makes the correlation work is the balance of demand and supply. But there are a couple of pairs that we know move hand in hand like EURUSD and USDCHF go the opposite directions, EURUSD and GBPUSD go the same way, likewise JPY pairs, etc.. Online correlation tables provide the exact numbers of correlation for a given time period. But isn’t it the market size of a currency that designates the correlation of it against other ones? In this case, EUR correlations must be greater than JPY correlations but what we see at the correlation tables is JPY correlations is higher than all other, even than the EURUSD vs GBPUSD, or USDCHF.

In the “Market Size and Liqudity” section at School of Pipsology, the currency distibution of major pairs are presented as below:

USD % 84.9
EUR % 39.1
JPY & 19
GBP % 12.9

Currency composition of world FX reserves are:
USD % 62
EUR % 27
GBP % 4
JPY % 3

So, what I gather from this is the Demand & Supply outdo the market size. Or should I say Demand & Supply can outdo the market size. Because while the USD is the King in the markets, the second one seems to be EUR, obviously not JPY. But the effect in reality is mostly done by JPY.

Last Friday,April 6th, because of the Easter there wasn’t much move in the markets and there were only two major news releases that were from USA and they affected the USD pairs negatively.

During this news, some pairs went up and some down. EURUSD, GBPUSD, NZDUSD went up while USDCHF, USDJPY went down which is what everyone expects in such situations. But what about some others that took this news the opposide way? Like USDCAD and AUDUSD which went down. All EUR pairs went up except EURCHF and EURJPY and also all GBP pairs except GBPCHF and GBPJPY.

Now, what I understand from Friday’s correlation moves is just because a currency let’s say EUR or GBP gained power against USD doesn’t mean all EUR pairs or GBP pairs will go up, cause another one such as JPY also may become demanded against USD more that it’s demand was more powerful than EUR and GBP , so JPY beat them too, though they beat USD for that hour.

Did I get that right, or is it usual to ponder aimlessly like this for tranquil market days

[Miner]

Hi, Metin. My advise is that. Don't waste your time trying to find a winning combination from correlations in forex. The reason is simple. You have to look currencies pairs in triangles not pairs e.g the movement of EUR/USD cannot be explained only from the movement of GBP/USD, because there is a third pair in the equation EUR/GBP so any "divergence" in the "major set (eur/usd, gbp/usd) absorbed from the movement of the third pair. In finance this is called triangle arbitrage and be sure that when any very small imbalance occurred in the market instantaneously this imbalance identified and eliminated from automate programs in major dealing desk So, the study of correlation is useful when you take into account the third respective pair or if you try to implement risk management procedures. One step ahead.... if someone argue that may earn risk less profit from the study of correlation in forex pairs...simply ignore him.

[purplepatchforex]

I trade a strategy that uses a form of correlation but only for short movements in price, when there is momentum in the market, it's a very specific strategy using the GBP/USD, EUR/USD, EUR/GPB and USD/CHF as detailed here - The Complete Cat and Mouse System with Money Management

BUT using correlation for the purpose you've been looking at is not really very useful, you are better off analysing charts individually.

Correlation and dependence - Wikipedia, the free encyclopedia

'In statistics, dependence refers to any statistical relationship between two random variables or two sets of data'

[rhodytrader]

I have a question on the correlation of currencies. As is known, currency pairs are all correlated

You need to differentiate between the correlation of currencies and the correlation of pairs. Pairs correlate because they include a common currency (or very closely related ones). Currencies correlate because they are impacted by a common set of factors during a given period of time.

[metin]

Thank you everyone,

Actually my concern is I have experienced something about correlation last week. Last Wednesday I traded two USD pairs and two JPY pairs, all hit the TP levels. The next day, I traded 3 USD pairs and 3 JPY pairs, these ones hit the TP levels too. But on Friday, of six trades I had opened, one was a JPY pair and all others were USD. I didn't feel comfortable about it because it was against my correlation balance rule. But I thought what the heck, all trades looks nice and I jumped in. If I had opened less USD pairs and one or two more JPY pairs, my profit would be greater than all other USD pairs (not all the USD pairs I traded last week hit the SL though, I closed three of them breakeven, one SL, one still in loss, not closed).

I'm not trying to find a winning formula but just to balance the trades. Thanks again.

[Fxmall]

If I had an easy answer to this, would be busy placing my trades. If you are looking into correlation, there's a wealth of info [both here and elsewhere] on the same. Currencies do correlate but not in the way that's painted out here..