Currency Pairs Correlation in Forex Market: Cross Currency Pairs

by Vahid | Forex Basics | Tuesday, August 25th, 2009

As a forex trader, if you check several different currency pairs to find the trade setups, you should be aware of the currency pairs correlation, because of two main reasons:

1- You avoid taking the same position with several correlated currency pairs at the same time and so you do not multiply your risk. Additionally, you avoid taking the positions with the currency pairs that move against each other, at the same time. 2- If you know the currency pairs correlations, it may help you to predict the direction and movement of a currency pair, through the signals that you see on the other correlated currency pairs.

Now I explain how currency pairs correlation helps. Lets start with the 4 major currency pairs: EUR-USD ; GBP-USD ; USD-JPY and USD-CHF.

In both of the first two currency pairs (EUR-USD and GBP-USD), USD works as the money. As you know, the first currency in currency pairs is known as the commodity and the second one is the money. So when you buy EUR-USD, it means you pay USD to buy Euro. In EUR-USD and GBP-USD, the currency that works as the money is the same (USD). The commodity of these pairs are both related to two big European economies. These two currencies are highly connected and related to each other and in 99% of the cases they move on the same direction and form the same buy/sell signals. Just recently, because of the economy crisis, they moved a little differently but their main bias is still the same.

What does it mean? It means if EUR-USD shows a buy signal, GBP-USD should also show a buy signal with minor differences in the strength and shape of the signal. If you analyze the market and you come to this conclusion that you should go short with EUR-USD and at the same time you decided to go long with GBP-USD, it means something is wrong with your analysis and one of your analysis is wrong. So you should not take any position until you see the same signal in both of these pairs. Of course, when these pairs really show two different direction (which rarely happens), it will be a signal to trade EUR-GBP. I will tell you how.

Accordingly, USD-CHF and USD-JPY behave so similar but not as similar as EUR-USD and GBP-USD, because in USD-CHF and USD-JPY, money is different. Swiss Franc and Japanese Yen have some similarities because both of them belong to oil consumer countries but the volume of industrial trades in Japan, makes JPY different.

Generally, when you analyze the four major currency pairs, if you see buy signals in EUR-USD and GBP-USD, you should see sell signals in USD-JPY. If you also see a sell signal in USD-CHF, then your analysis is more reliable. Otherwise, you have to revise and redo your analysis.

EUR-USD, GBP-USD, AUD-USD, NZD-USD, GBP-JPY, EUR-JPY, AUD-JPY and NZD-JPY usually have the same direction. Just their movement pattern sometimes becomes more similar to each other and sometimes less.

What do I prefer?

If I find a sell signal with EUR-USD and GBP-USD and a buy signal with USD-JPY, I prefer to take the short position with one of the EUR-USD or GBP-USD because downward movements are usually stronger. I will not take the short position with EUR-USD or GBP-USD and the long position with USD-JPY at the same time, because if any of these positions goes against me, the other one will do the same. So I don’t double my risk by taking two opposite positions with two currency pairs that move against each other.

How to use the currency pairs correlation to predict the direction of the market?

When I have a signal with a pair, but I need confirmation to take the position, I refer to the correlated currency pairs or cross currency pairs and look for the confirmation. For example I see a MACD Divergence in USD-CAD four hours chart but there is no close support breakout in USD-CAD four hours or one hour chart. I want to take a short position but I just need a confirmation. If I wait for the confirmation, it can become too late and I may miss the chance. I check a correlated currency pair like USD-SGD and if I see a support breakout in it, I take the short position with USD-CAD. Now the question is why I don’t take the short position with USD-SGD and I use its support breakout to go short with USD-CAD? I do it because USD-CAD movements are stronger and more profitable. I use USD-SGD just as an indicator to trade USD-CAD.

It happens that you take a position with a currency pair, but it doesn’t work properly and you don’t know if it was a good decision or not. On the other hand, you don’t see any sharp signal on that currency pair to help you decide if you want to keep the position or close it. In such cases, you can check a correlated currency pair and look for a continuation or reversal signal. It helps you to decide about the position you have.

Sometimes, some correlated currency pairs don’t move in the way that they are supposed to move. For example EUR-USD and USD-JPY go up at the same time, whereas they usually move against each other. It can happen when Euro value goes up and USD value doesn’t have a significant change, but at the same time JPY value goes down, because of some reason. In these cases, you can use the below table to find and trade the currency pair that its movement is intensified by an unusual movement in two other currency pairs. In this example, if EUR-USD and USD-JPY go up at the same time, EUR-JPY will go up much stronger (see the below chart).

Or if EUR-USD goes up and AUD-USD goes down at the same time, EUR-AUD goes up strongly.

Another important example: If EUR-USD goes up and GBP-USD goes down at the same time, EUR-GBP goes up strongly. Maybe this is the most important case that we can trade based on this rule. It happens many times that EUR-USD and GBP-USD move against each other and that is the best time to trade EUR-GBP. Now you know why EUR-GBP doesn’t move strongly most of the time. It is because EUR-USD and GBP-USD move in the same direction most of the time. For example they go up at the same time and so EUR-GBP doesn’t show any significant movement because when both of the currencies of a currency pair go up or down at the same time, that currency pair doesn’t show any strong movement and direction (I hope you know why a currency pair goes up or down. It goes up when the first currency value goes up OR the second currency value goes down. For example EUR-USD goes up, if Euro value goes up or USD value goes down. If this happens at the same time, then EUR-USD goes up much stronger).

The below chart includes almost all of these unusual movements and their results on the third currency pair.

if EUR-USD and USD-JPY then EUR-JPY means if EUR-USD and USD-JPY go up at the same time, then EUR-JPY goes up much stronger.

Further Reading:

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Comment by JimS

2009-08-26 00:04:43

Thanks Vahid. I find that correlation can be confusing and you explained it very clearly. I am going to bookmark this article.