Correlation is a statistical indicator which, when applied to Forex markets, measure the extent to which two currency pairs move in the same, opposite, or completely random directions over a period of time.
Analysis of pairs relationships using historical data is useful to forecast future trends. By utilising the correlation coefficient, we can understand the relationship between two values and help manage risk. The coefficient is between -1 to +1.
A correlation of +1 means that two currency pairs will move in the same direction. The correlation between EURUSD and GBPUSD is a good example: if EURUSD rises, then GBPUSD rises as well.
A correlation of -1 indicates that two currency pairs will move in the opposite direction. EURUSD and USDCHF have a perfect negative correlation, thus if EURUSD rises, then USDCHF falls.
A zero correlation means the relationship between currency pairs is completely random, or they have no link at all.
Naturally, the stronger a positive or negative correlation, the higher a predictive value is drawn from the analysis. More extended time frames display more precise information compared to relationships over one minute, which have a little value. Monthly and yearly data generally provide the most reliable insight.
The analysis of correlations is useful to build rewarding Forex trading strategy, so that a trader can measure the amount of risk he is exposed to within his Forex trading account. For example, if a trader buy several pairs with a strong positive correlation, then they are exposed to higher directional risk. He can avoid positions that effectively cancel each other out. EURUSD and USDCHF show a strong negative correlation. In a directional bias case, buying both these pairs will counteract the moves in each one.