How to use Correlation in Trading
Using correlation to trade will make a lot of difference in your trading, especially if you are the type that loves to trade a lot of pairs. Correlation literarily means the relation between two or more variables. A systematic change in the value of one variable is accompanied by a systematic change in the other. That is the same in trading as well. A change in the strength of a currency will affect the state of all the pairs that have the particular currency. For instance, if the FEDs decided to cut the interest rate on the US dollar, all pairs that have USD will be affected. That is what currency correlation is all about in trading and, if you know how well to use it, your trading journey has just gotten better.
The strength of all currencies is not always the same, some are safe-haven currencies (CHF, JPY...) and investors use them to hedge against inflation. Currency's strengths differ, and this is when correlation becomes more effective in trading the forex market. If some currencies are strong, some will be weak. For instance, let's assume that the US dollar is weak, so all pairs that have USD on the left side i.e. USD/JPY, USD/CHF, USD/CAD, etc., will be in a downtrend because the US dollar is the base currency in those pairs. And pairs that have USD on the right-hand side i.e. EUR/USD, GBP/USD, AUD/USD, NZD/USD, etc., will be in an uptrend because USD is the quote currency in these pairs. So, all USD pairs are doing the same thing, or let me say they are correlating.
Trading using correlation does not mean you should be trading all the pairs in the market, it only allows you to pick the best pair and be sure of the direction the market is going. From the instance illustrated above, the weakness of the US dollar will make some pairs go down and some will go up. But, have you noticed that even when the US dollar is weak, some pairs tend to drag while the movement of others is fast and smooth, more like the market is running away. These pairs barely give entry.
To effectively use correlation, the strength of other currencies has to be determined. Having known the strength of other currencies, you will know the pair that will drag, the ones that will run away, and the ones that quietly move and give entry. This is called FILTERING. You are filtering out the best pairs in the currency group.
A pair with a strong currency against the weak US dollar will not give a precise entry; it moves very fast and barely give a decent entry. A pair with weak currency against the weak US dollar has a draggy movement. This kind of pair may either be in a range or chop around. But a pair that has a neutral currency against the weak US dollar gives precise entries and even pullback to S&R areas to add more positions. So, if you notice this kind of thing in the market when doing your analysis. You now have a better idea of what to do.
Pairs with strong currency against weak currencies usually move very fast and are the LEADERS in that currency group, the ones with a neutral currency are the SECOND LEADER (majorly the best to pick) and the ones with a weak currency are called the LAGGARDS. Their movement lags and doesn't move that much. You might decide to go with a leading pair, but don't expect a pullback. The second-leading pairs give decent pullback and also have precise entry.
Now that you know how to use correlation to trade effectively. If you do your analysis for each currency group, you will be able to pick one or two trades from each currency group. The result is going to be amazing. This is why using correlation to trade is a great idea. If nothing is happening on a particular currency, you will know which pair to stay away from. It also enables you to trade many pairs once you understand what the market is doing, especially during a volatile period in the market.
If you are the type that loves trading many pairs at a time, it is advisable to reduce your position size in case of the inevitable(losses). Correlation allows you to trade many pairs, filter out trade opportunities and, give more confidence in the trade opportunities.
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