Currency pairs are interrelated in the forex markets. As a forex trader, understand that the price action of each currency pair is not independent of other.
Different currency pairs move relative to one another. You need to understand that different currency pairs are correlated. Correlation can be positive or negative.
Knowledge of how strong this relationship is and its direction can help you in developing your trading strategies with a new perspective. This has the potential to become a great trading tool for you.
Correlations are calculations based on past pricing data between different currency pairs. It is always a number between -1 and +1. These numbers can provide you with a lot of information that can maximize returns, minimize risk and help you avoid counter productive trading.
Lets take an example. Suppose USD/JPY and USD/CHF had a positive correlation of +0.83. This number is close to +1. It means that both the pair move together most of the time.
Since both the pairs move together, if you are trading USD/JPY and USD/CHF at the same time, it will double up your position if you go long or short on both at the same time. In other words, if you lose a trade on USD/JPY, the chances are that you will also lose the trade on USD/CHF 83% of the times.
Lets take another example to elaborate more. EURUSD and USDCHF both have a negative correlation of -0.92 in the last month. Both the pairs are moving in opposite directions recently. If you take long position on EURUSD, it is not a good strategy to take short position on USDCHF. It will only double up your position with increased risk.
While investing in two currency pairs simultaneously, try to choose such pairs that have correlations close to zero. Zero correlation means the two pairs are almost independent of each other and mutually exclusive.
Always keep this in mind that currency markets are constantly changing. The correlation between currency pairs also keep on changing. It would be a good idea to calculate the correlations between pairs on a monthly basis.