Correlation between currency pairs can be one of the most beneficial things for a forex trader who wants to trade in multiple currency pairs because it can help him or her understand the relationship between the foreign exchange rate movements of those two currency pairs. However, in order to use correlation in the right manner, it is important to understand what it is.
Correlation between currencies is basically used to measure their relationship. There are mainly three types of situations that can arise because of this. The first is that there is positive correlation which is usually expressed in a value between 0 and 100. The second is negative correlation expressed by numbers between 0 and -100 and the third is no correlation expressed by 0.
If you know these basics then you can use correlation for a wide variety of purposes. What uses can correlation values be put to? Consider the following.
Most traders tend to back test their strategies so as to figure out whether they are useful or not. However, most traders also just test their strategies on the basis of the historical foreign exchange rate of one currency pair. With the use of correlation values, you can actually choose to test your strategy on various types of currency pairs.
This way you would increase the amount of data that you can use for testing. Furthermore, this would also increase your test results which would also vary in terms of the used foreign exchange rates. This diversification means that you get to analyse the efficacy of your strategies in a more comprehensive manner.
As you move from being new to foreign exchange rate movements to becoming experienced, you would gain more confidence about using your strategies on multiple currency pairs. Without the knowledge of correlation values, this would become increasingly difficult and extremely risky for you.
However, if you were to use correlation values to understand the relationship between various currency pairs, you will find it easier to implement your strategies on multiple currencies simultaneously. Thus, multiple profitable positions would become possible for you.
As correlation values would allow you to multiply your positions with minimal risk, you would essentially be doubling or even quadrupling your profits. With proper use of correlation values, you can prevent risks from multiplying while ensuring that your profits double up.
However, you must make sure to take everything from margin levels to drawdowns into account if you are going to attempt such a complex operation because foreign exchange rate movements can be very unpredictable.
Hedging is one of the most difficult concepts to implement in forex trading. This is especially true for new forex traders who are yet to acclimatise themselves to various currency pairs and their foreign exchange rate movements. However, experienced traders often use correlation values to implement hedging strategies.
Hedging will usually be done on the same currency pair but it is possible to hedge with two different currency pairs that are related in some manner. Correlation values would help you arrive at a relation between the foreign exchange rate movements of two different currency pairs.
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