TRADING CURRENCY CORRELATION
Say, for example, that you’ve located the following data on currency correlation coefficients (see Table 7.4
) and determined the following:
• The GBP/USD moved the same as the EUR/USD 68 percent of the time.
• USD/CHF moved in the opposite direction of the EUR/USD 97.5 percent of the time.
Armed with this kind of information, you can avoid entering two different positions that would likely cancel each other out.
By knowing that EUR/USD and USD/CHF move in opposite directions most of the time, you would conclude that having an open long trade in EUR/USD, while also being in a long USD/CHF trade, is the same as having virtually no position at all. The two trades would effectively cancel each other out, due to the negative correlation exhibited by these two pairs.
In other words, when your long EUR/USD position moves up in price, your USD/CHF long will be going down by nearly the same amount, resulting in a pretty pointless trade at double the spread cost.
Instead, the savvy trader, understanding this negative correlation, would enter both a long EUR/USD position and a short USD/CHF position—basically, shorting the USD in two different trades. However, you are diversifying your USD bearish investment.
More importantly, you can make trade entry and exit decisions based on currency correlation. Say, for example, the GBP/USD starts showing some volatility and approaches a resistance level. While you anticipate entering a long trade on a breakout, ...