The observation of correlations among currencies can help a trader to hedge or diversify his exposure to the Forex market.
If he has a directional bias for a given currency, he can spread the risk by using two strongly positive correlated pairs, in terms of diversification.
In order to hedge a position (holding it with low risk of losses) a trader can take a position in a negatively correlated pair. If he were to follow a ‘long buy’ strategy on EURUSD, and this begins to move in an unfavourable direction, a trader can then hedge his position by purchasing a pair that has a negative correlation to EURUSD. USDCHF could be a good choice.
When two currency pairs are highly positively correlated, one can serve as a leading indicator of the price movement of the other. If a sharp move in one of the two is observed, a move in the other can then be predicted.
When two currency pairs are highly negatively correlated and a significant upward price reversal in one pair occurs, then a trader can anticipate a potential downward reversal in the other pair.
An abnormal divergence between two highly correlated pairs can be exlpoited to buy one and sell the other, with the expectation that they will converge in price movement again. This is an example of a non-directional arbitrage strategy which exploits currency correlations.
Examples of strong positive correlations (Yearly time frame):
EUR/USD and GBP/USD (+ 0.89)
EUR/USD and AUD/USD (+ 0.81)
EUR/USD and EUR/CHF (+ 0.93)
AUD/USD and Gold (+ 0.75)
Examples of strong negative correlations (Yearly time frame):
EUR/USD and USD/CHF (- 0.85)
USD/CAD and AUD/USD (- 0.88)
AUD/NZD and NZD/SGD (- 0.78)
USD/JPY and Gold (- 0.78)