Risk exposure

Now that you have a good understanding of currency correlations, it is time to put your knowledge to work. Currency correlation is a key metric is assessing your risk exposure when trading multiple currency pairs.

For illustration purposes let us take an example of the EUR/USD and the GBP/USD. The two pairs have a very high positive correlation, meaning, when one moves in a direction, so does the other. If you buy 1 lot of EUR/USD and 1 lot of GBP/USD, it is as good as buying two lots of EUR/USD or GBP/USD. You just doubled your risk profile!

On the flip side if you enter two opposite positions, it defeats the purpose of that trade. For instance, if the EUR/USD and USD/CHF have a negative correlation of -1; they virtually cancel each other out, which is counterproductive.

However, using currency correlations properly you can achieve some diversification. The EUR/USD and AUD/USD usually has a positive correlation less than 1. Experienced traders diversify risks by taking equal positions in EUR/USD and AUD/USD. Different monetary policies and trade relationships (Australia's strong trade partnership with China) result in different impact during time of USD rally.

As you can see, irrespective of which currency pair(s) you are trading on, it is vitally important to be aware of correlations it has with other currency pairs. Its tools give professional traders an edge over novice others.

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