Back in part one, we had a look at positive and negative correlated pair explanations and how some currency spreads work, so let’s now take a look at some other type of correlations:
Geographical correlation :
When you trade the Canadian Dollar through, for example, a USD/CAD pair, you are betting for a lack of US Dollar. Canada is one of the largest partners to the United States, so you may look for all poor USD eco data that may affect this pair and reinforce the strength of the Canadian economy. Obviously, bad data from Canada reinforces the US Dollar within the USD/CAD pair too. You may also consider looking at the USD/YEN pair to confirm any move in this matter.
The same idea applies to the Australian Dollar against the New Zealand Dollar regarding their economic data. AUD/NZD have a certain correlation due to the proximity of the countries, so you must look at this when you trade AUD/USD or NZD/USD. One of them may move faster than the other, considering the strength of the AUD/NZD in their economic data.
Of course, it’s very challenging to follow every piece of economic news released each day. In this case, just pay attention to important events and try to learn how correlations between pairs/countries move on published reports.
Large banks and hedge funds have developed complex mathematical models to track these FX correlations but, at your level, just check how related currencies are trending. When preparing a trade, it always helps to reinforce your knowledge.
A quick trick that can help – Let’s see how correlation can help you to avoid a bad trade :
Let’s say you are mainly trading EUR/USD on a breakout strategy. Let’s also say that, at the same time, GBP/USD – NZD/USD pairs also have a positive correlation. The idea is simple, how do other pairs move before entering a trade? Have GBP/USD – NZD/USD already made this breakout? Are they turning around?
Use other correlated pairs as filters to decide whether or not to enter a trade or to exit. Believe me, it works better than any other indicators. Advanced traders may also take a look at Crossed in this example (EUR/GBP – GBP/NZD) to provide an even better filter.
Use it without limitation!