The rise or fall of a currency pair on Forex cannot occur in isolation, without affecting other assets, since the value of the quote depends more on external fundamental factors that affect both currencies included in the pair. Speculative actions are too short-term and do not have sufficient liquidity to influence medium- and long-term trends. Correlations provide an opportunity to see and profitably exploit the relationship of price movements.
The correlation effect should be considered only as the first signal of the opportunity to open a trade, then it is confirmed by the data of technical analysis.
Let’s start with an inverse or mirror correlation, in which the opposite movement is clearly visible, as in the figure. The reason for this trend is in the structure of the currency pairs used:
- a direct USD / CAD quote showing how many Canadian dollars are contained in the US dollar;
- inverse EUR / USD, where you can see how many US dollars includes the euro.
We can say that the dollar in both pairs is “on opposite sides of the market” and an analogy can be drawn with communicating vessels: a decrease in the euro leads to a movement of dollar volumes to other pairs with its subsequent strengthening. Accordingly, the euro strengthens during periods of dollar decline.
In direct or positive correlation, two forward or reverse quotes are used. At the same time, the graphs move synchronously, albeit with a delay. Typically, EUR / USD is used as the leading indicator in combination with the slower AUD / USD and NZD / USD.
Correlation calculator and trade examples
Visual search for price convergence / divergence takes a lot of time, and in order not to miss a good moment to enter, calculators have been developed that calculate the coefficients of the “strength” of the correlation. The calculation methods are different for each service, but in general, the trend is determined correctly. The figure shows an example of such a calculator from OANDA, one of the world’s largest Forex brokers.