Correlation is a statistical measure of the relationship between any two items. The value of correlation varies from -1 to +1. In our context, a correlation of +1 implies that the two currency pairs will move in the same direction 100% of the time. A correlation of -1 implies the two currency pairs will move in the opposite direction 100% of the time. If the movement of one pair doesn't tell anything about the movement of the other pair then there is zero correlation between these pairs.
Expert traders who have a portfolio under management try to get a comprehensive picture of the market volatility on their portfolio. Since a currency pair price is relative to other currency pairs there is always some relationship between them. Correlation is a good measure of this relation. Once you are aware of these correlations and how they change, you can use them control your overall portfolio's exposure.
All correlations are as follows:
1. Weak: the absolute value of the correlation coefficient is between -0.3 to +0.3.
2. Medium: the absolute value of the coefficient is greater than 0.3 but less than 0.5.
3. Strong: the absolute value of the coefficient is greater than 0.5 but less than 0.8.
4. High: the absolute value of the correlation coefficient is equal to or greater than 0.8.
It's easy to understand correlation if you trade in derived pairs such as GBP/JPY. Since this pair is derived from GBP/USD and USD/JPY pairs, it is likely, that GBP/JPY is correlated to one or both of the parent pairs.
Note: Trading multiple currency pairs is not necessarily diversification as in stocks. Though you are hedging risks by investing in two economies, a positive correlation can in fact increase your risk profile.
There are many factors that affect exchange rates of currencies. However some are more important in currency trading than others. These are; Interest and Inflation rates, Trade balance, Currency market speculation, Foreign investment and Central bank market intervention. Learn how to use these factors in your forex tra ...