Usually professional forex traders have more than one currency pair in their trading accounts. In relation to this it is very important to understand that all major currency pairs are interdependent of one another, and no currency pair is traded separately of others. It is common that trading currencies are correlated, and if a forex trader understands the essence of these correlations, he/she can make a profitable use of them in order to manage the money better.

The reason of the currency correlations lies in the fact that there exist major currency pairs in the forex market, and the rest of the trading currencies are actually the derivatives of the majors. For instance, when the Yen is traded against the Swiss franc in a JPY/SCF pair, it means that in fact the derivative of JPY/USD and USD/SCF pairs is traded. A conclusion that follows is that JPY/SCF pair should be correlated to one or both above mentioned currency pairs. Moreover, some currency pairs in correlations move in the same direction (for example, an uptrend is observed for the both pairs), while some can move in the absolutely opposite directions (there is an uptrend for one currency pair and a downtrend for another).

As far as currency pairs are concerned, correlation coefficient for them can range between -1 (negative correlation) and +1 (positive correlation). The former means that the direction of movement is opposite for the two currency pairs for 100% of time, while the latter means that the direction of movement for currency pairs is the same for 100% of time. There can be also zero correlation, which means that the relationship between currency pairs is absolutely casual.

Certainly, correlations between trading currencies tend to change over time. Factors that contribute to this change are the macroeconomic conditions and traders’ sentiment; thus, correlations can change even every day. It is also very important to remember that it is impossible to make long-term predictions for the currency pairs correlations, since the forex market state of affairs one day may not coincide with the state of affairs, let’s say, in a month. In order to have a better view for analyzing currency pairs correlations, it can be a reasonable idea to take a look on a half-a-year time range chart. The reasons why these correlations can change are usually the difference in the countries’ fiscal policies and some trading pair being sensitive to commodity prices, in addition to individual political and economic factors influencing the currencies’ countries.

Knowledge about the trading pair’s correlations can prevent the forex trader from entering two self-excluding trading positions. The key thing here is that some trading currencies can’t be traded at the same time since they move in the opposite directions. However, if a trader is aware that certain currency pairs move in the same direction, he/she can double up the profit on the same position.

One more important point for a forex trader to consider is that for many currency pairs the correlation is traditionally not 100% positive or negative, which permits more diversification and reduces the risks.

On the whole, knowing about the currency pairs’ correlations allows the forex trader to make trading decisions and manage the money more effectively.

Written by Alexander Collins co-founder of ForexEASystems that provides forex trading systems and forex strategies.