In trading, “correlation” is a statistical measure that describes the degree to which two securities move in relation to each other.

Correlations are used in advanced portfolio management and are computed using the correlation coefficient, which ranges between -1 and +1.

Here’s what those values indicate:

Positive Correlation (values close to +1):

This suggests that the two securities move in the same direction at the same time. If one security rises, the other tends to rise; if one falls, the other also tends to fall.

For example, EUR/USD and GBP/USD often move in the same direction because both pairs are correlated with the USD.

When the USD weakens, both EUR/USD and GBP/USD often rise; when the USD strengthens, these pairs typically fall.

Another example could be two stocks within the same industry, which might both benefit from the same economic factors.

Negative Correlation (values close to -1):

This indicates that the two securities move in opposite directions. If one security’s price increases, the other’s tends to decrease, and vice versa.

For example, in currency correlations, EUR/USD and USD/CHF typically exhibit negative correlation.

When the USD is weak, the EUR/USD might increase, while USD/CHF might decrease.

Another example might be certain stocks and bonds, as they often move inversely to each other.

When stocks are doing well, bond prices might decrease as investors move towards the higher return (and higher risk) stocks, and vice versa when stocks are doing poorly.

No or Zero Correlation (values close to 0):

This suggests that the price movements of the two securities have no detectable pattern in relation to each other.

Why is correlation important?

Correlation is a crucial concept in diversification, which is the strategy of combining various different investments in a portfolio to reduce risk.

The idea is that if investments are not perfectly positively correlated, some will rise as others fall, balancing out the performance of the portfolio.

Understanding forex correlation is useful in managing exposure and risk.

For instance, if you have a positive exposure to the EUR/USD, you might choose to offset some of that risk by taking a negatively correlated position on the USD/CHF.

However, it’s important to remember that correlations can change over time due to changes in market conditions, geopolitical events, or economic factors.