Tools, tools, tools! Hand me some nails please. Hammer too! What good are nails without a hammer? Now hand me that currency correlation… Wait. What? Don’t know what correlation is? Well, good thing you found this article then because it’s one of the most important things a trader must be aware of when trading currencies, one of the four fathers of binary options. Anyway, don’t expect UP and DOWN arrows… no, no, that’s not how correlation works so keep reading only if you are serious about trading.
If I were to hit my head on a wall I would get a headache for sure. There’s a direct correlation between my action and the headache that follows and this idea holds true in the financial market as well. Of course, the euro or the dollar will not go around bashing their heads against walls, but correlation exists and you must be very aware of it because it’s an important part of trading. That being said, let’s begin.
What is Currency Correlation?
Have you ever noticed similarities between the movements of currency pairs? Yes? Then you probably saw currency correlation at work. Take a look at EUR/USD and GBP/USD and you will be amazed to see they follow each others movement. If one goes UP, the other follows. Same for moves to the south. Of course, they are not mirror images of one another but the overall direction is the same. When two pairs move in the same direction, they are positively correlated, just like EUR/USD and GBP/USD or EUR/JPY and USD/JPY. However, there is another type of correlation which… you guessed right, it’s called negative correlation. When two pairs are negatively correlated, they move in almost completely opposite direction: if EUR/USD makes a higher high, almost certainly USD/CHF will make a lower low of similar size. In other words, if EUR/USD goes UP, USD/CHF goes DOWN. To keep it simple: positively correlated pairs move overall the same and negatively correlated pairs move in opposite directions. However, they will not move 100% identical or opposite.
Think about it like this, the chart patterns made by one of them will be inverted by the other. In other words, if the EUR/USD shows a Double Top, USD/CHF will make a Double Bottom. If EUR/USD moves Up, USD/CHF moves Down. There are a couple of reasons for this: first of all, notice the position of the USD in the two pairs under discussion. In EUR/USD the dollar is the second currency in the pair while in USD/CHF it is the first. Whenever the second currency in a pair strengthens, the pair goes Down and if the first currency strengthens, the pair goes Up. With that in mind, if EUR/USD goes Down, it means the USD strengthens but if it strengthens, that means USD/CHF will go Up because as I said earlier, if the first currency in a pair strengthens, the pair will go up. Yea, I had to read it again to make sure I didn’t make a mistake and I am sure it can sound complicated if this is the first time you’ve read something like this.. but the ordeal is not over so take a break if you want because I’m going to explain the second reason.
The two pairs we are talking about are composed of three currencies: EUR, USD and CHF. As you might have guessed, the third currency has something to do with the pair’s movement as well. To understand its role, you will have to take a look at EUR/CHF or to take my word for it: that pair has minimal movement and this means that the EUR/CHF rate is very constant. What I am going to say is not the most correct or accurate from a financial point of view, but it will help you understand: because their movement is so slow, you could say that EUR is CHF and vice versa, they are equal, they are the same. So actually when we are comparing EUR/USD and USD/CHF we could say we are comparing EUR/USD and USD/EUR. If the third currency in our pairs has no relevance (almost), then all there is left is the position of the currencies in the pair. Since the USD is the last currency in one pair and the first in another, it is normal that the two pairs will move in opposite directions almost always.
And because all this turned out to be more complicated than I thought, I am going to tone it down a bit for those of you that are not used with all this technical talk. What we know so far is that some pairs move in opposite direction. Also, some of them move in the same direction, so we need to pay attention to what pairs we are trading. Think about this: if you have a Call on EUR/USD and a Put on USD/CHF and you win the Call, you will most likely win the Put as well. Remember if EUR/USD moves Up, USD/CHF moves Down. If you have two Calls (one each pair), you will most likely lose one of them and win the other. This opens the door for a lot of money management and hedging techniques: if you want to maximize your potential profit, you can open opposite trades on currency pairs with opposite movement (we call these negatively correlated pairs). But you must remember that this also increases risk; it’s great if the pairs move in your direction but otherwise, you can end up losing both of them. Looks like I didn’t kept my promise of making it simpler… well, blame it on correlation. Maybe the summary that follows will help. Keep in mind that pairs which move the same way are positively correlated and pairs that move the opposite way are negatively correlated.
Correlation Coefficient – Don’t Worry, there’s No Math Involved
Now that you have an idea what correlation is, you might be wondering how to know exactly which pairs are correlated, how high the correlation is and if it’s negative or positive. Well, don’t worry, you don’t have to memorize currency pairs and their correlation values; all you have to do is follow this link: http://www.forexticket.com/en/tools/01-01-correlation and check out the tables presented there. Usually correlation above 80 is considered strong and positive (pairs move similar); correlation below -80 (minus 80) is considered strong negative (pairs move in opposite directions). You will also notice that the time frame of the chart affects the correlation coefficient. For example two pairs can be strongly correlated on an hourly chart but not so much on a 5 minute chart. Another thing to note is that correlation changes over the course of time so it would be a good idea to check the link above regularly.
Some Rules For Trading Currency Correlations
- Same direction trades on positively correlated pairs increase potential profit and increase risk
- Opposite direction trades on positively correlated pairs decrease both potential profit and risk
- Same direction trades on negatively correlated pairs decrease both potential profit and risk
- Opposite direction trades on negatively correlated pairs increase both potential profit and risk
Why does Currency Correlation Suck?
Maybe you wondered what’s the connection between the title “Double or nothing?” and currency correlation, maybe it has something to do with gambling? Well let me explain: if you trade in the same direction on two positively correlated pairs (these pairs move similar) and one of them goes against you, what do you think will happen to the other one? It will go against you as well… so you lose Double. I bet before you knew about correlation you didn’t find an explanation why both your trades went wrong. Now you know ;) However, if you open opposite trades on negatively correlated pairs (i.e. a Put on EUR/USD and a Call on USD/CHF) and one of them goes against you… guess what: you will probably lose them both. Money in the pocket of the broker…
Why Currency Correlation doesn’t Suck?
Let’s say you want to limit your risk. With the use or correlation you can do that by opening opposite trades on positively correlated pairs or trades in the same direction on negatively correlated pairs. Say you open a Call on EUR/USD and a Call on USD/CHF; since these are negatively correlated pairs which usually move in opposite directions, chances are that you will win one of the trades, hence limiting the potential loss.
Wrapping it up – To Use or Not to Use?
No matter if you choose to use it or not, correlation exists. It’s a feature of the market and more than that, it is not a matter of whether correlation sucks or not. It’s all about being aware of it and knowing that it can double your profits as well as your loses. However, being aware is 100% the job of the trader. So if you want to be aggressive, use correlation to double your profits or use it to hedge a position if you want to be more conservative. It’s all up to you.
Correlation can help you get out of a hairy situation, can maximize your profits but it can also be your enemy because it can make you lose more than you originally intended. In other words, it can be both Friend and Foe, depending on your understanding of the market and risk appetite. If you want to risk more, increasing your profit potential at the same time (or the other way around), correlation can help you do that. For this article I only used a few pairs as an example, but most pairs are correlated to some extent with other pairs they share currency with.
Currency Correlation, Account Diversification and Binary Options Copy Trading
Currency correlation is an important factor for anyone trading forex or forex based options. Even binary options, even when you are copy trading. If you are not aware of currency correlation let me enlighten you. Some currencies and currency pairs are tied together, when one moves so does the other one. It is most common between pairs including one of the same currencies like EUR/USD and EUR/JPY but can also exist between seemingly unrelated pairs such as the EUR/USD and CHF/HKD which have been shown to move in tandem over multiple time frames. What makes currency correlation really confusing is that some moves move together, but in opposite direction.
Unwanted Correlations Add Risk For Binary Copy Traders
The reason why it is important to understand these correlations in terms of account diversification and copy trading is that you don’t want to double up on trades that are essentially identical, and you don’t want to make trades that are likely to cancel each other out. It is all to easy to jump from chart to chart, looking for signals, and forget that sometimes these charts have a big impact on each other. You may find identical signals occurring on multiple pairs and there is a reason for it; they are basically the same trade, moving on the same fundamentals and the same catalysts. You may at first think it a good idea to trade on 2,3 or 4 signals because you are spreading your risk around but if those trades are all looking for the dollar to strengthen you are really increasing your risk. If the dollar strengthens you win 4 times, but if it weakens you lose 4 times.
Adding risk is reason enough to be wary of correlations but there’s another reason to fear it; cancellation. Cancellation is when you trade on two pairs that move in opposite directions of each of other like the EUR/USD and USD/CHF. These two pairs, and many like them, will move in opposite direction of each other. Placing a call or a put on both at the same time has a higher chance of resulting in one win and one loss than it does in two wins or two losses. Trading like this ultimately will result in losses for binary traders because of the risk/reward ratios of trading. You never win as much as you lose on a trade by trade basis, it takes a win rate greater than 50% to be profitable.
Copy Trading Binary Options
Copy trading is supposed to help make trading easier but when you consider correlations and how they can affect your account you may not agree with that sentiment. Blindly following someone, or a couple someones, can result in major losses and currency correlation is only one method. You can try to avoid them through diversification but there is nothing to stop your traders from trading the same pairs, or pairs that cancel each other out, so you really have no control over your risk. This is why it is important to fully understand who and what you are copying, and to use copy trading as a tool for your trading education, not as your overall strategy.
The first step to avoid these risks in your account is learn as much as you can. Education is always the key. The more you learn the better able you will be to choose the right copy trading platforms and services, the more you learn the better able you be to choose the right traders to follow. As your education grows you will eventually learn to make good trading decisions and even make your own trades which should be your goal. If it isn’t you aren’t serious about making money trading binary options.
Social Trading Is The Answer
Once again the answer to the question, the solution to the problem so to speak, is social trading. Where copy trading is nothing more than following signals or auto-trading software, social trading takes signal trading to the next level through education and interaction that allows you to make proper decisions about your account and currency correlations. A few of the benefits include knowing who you are following versus following some avatar on a website, knowing the strategies employed, picking only the trades you want to follow/not all the trades a trader makes and the support of other traders like yourself. Yes, you can just copy the trades of other traders but you at least have the opportunity of picking and choosing which trades to follow. The bottom line though is that correlations can kill your copy trading account faster than a broker will call you back after signing up on their website. Open your first Social Trading Account with CommuniTraders Today!