If you are a forex trader, you may have heard of the term “correlation matrix“. But what is it and how can it help you to choose a currency pair to trade?
A correlation matrix is a tool that shows the relationship between different currency pairs in terms of how they move together or apart over a certain period of time. It is usually displayed as a table or a grid, where each cell shows the correlation coefficient between two currency pairs.
The correlation coefficient is a number that ranges from -1 to +1, where:
- -1 means that the two currency pairs are perfectly negatively correlated, meaning they move in opposite directions all the time.
- +1 means that the two currency pairs are perfectly positively correlated, meaning they move in the same direction all the time.
- 0 means that the two currency pairs are completely uncorrelated, meaning they move randomly and independently of each other.
Why is correlation important for forex traders?
Correlation is important for forex traders because it can help them to:
- Diversify their portfolio: By choosing currency pairs that are not highly correlated, traders can reduce their overall risk and exposure to market fluctuations. For example, if one currency pair suffers a loss, another currency pair may offset it with a gain.
- Identify trading opportunities: By choosing currency pairs that are highly correlated, traders can take advantage of market movements and trends. For example, if one currency pair breaks out of a range, another currency pair may follow suit and offer a similar trading opportunity.
- Avoid overexposure: By avoiding currency pairs that are highly correlated, traders can avoid placing too much weight on one market factor or event. For example, if two currency pairs are both affected by the same news release or economic indicator, trading both of them may amplify the risk and volatility.
How to use the correlation matrix to choose a currency pair?
To use the correlation matrix to choose a currency pair, you need to first decide on your trading strategy and time frame. Depending on whether you are a scalper, day trader, swing trader, or position trader, you may want to look at different timeframes and periods for the correlation matrix.
For example, if you are a scalper who trades on the 5-minute chart, you may want to look at the correlation matrix for the last 50 bars. If you are a position trader who trades on the daily chart, you may want to look at the correlation matrix for the last 200 bars.
Once you have decided on your timeframe and period, you can then look at the correlation matrix and identify the currency pairs that suit your trading style and objectives. Here are some general guidelines:
- If you want to diversify your portfolio, look for currency pairs that have low or negative correlation coefficients (between -0.5 and +0.5). This means that they tend to move differently or in opposite directions most of the time. For example, EUR/USD and USD/JPY have a negative correlation of -0.7 over the last 200 bars on the daily chart, meaning they move in opposite directions 70% of the time.
- If you want to identify trading opportunities, look for currency pairs that have a high positive correlation coefficient (above +0.8). This means that they tend to move in the same direction most of the time. For example, EUR/USD and GBP/USD have a positive correlation of +0.9 over the last 200 bars on the daily chart, meaning they move in the same direction 90% of the time.
- If you want to avoid overexposure, avoid trading currency pairs that have high positive or negative correlation coefficients (above +0.8 or below -0.8). This means that they tend to move in sync or in contrast most of the time. For example, EUR/USD and EUR/JPY have a positive correlation of +0.8 over the last 200 bars on the daily chart, meaning they move in sync 80% of the time.
Where can I find a correlation matrix?
There are many online tools and websites that offer free or paid correlation matrices for forex traders. Some examples are: Myfxbook
You can also create your own correlation matrix using Excel or other software programs.
Conclusion: Currency Pair Correlation
A correlation matrix is a useful tool for forex traders who want to diversify their portfolio, identify trading opportunities, or avoid overexposure. By understanding how different currency pairs move together or apart over time, traders can make more informed and strategic decisions.
However, it is important to remember that the correlation is not a fixed or constant value. It can change over time due to various market factors and events. Therefore, traders should always monitor the correlation matrix and update their analysis accordingly.
