Currency pairs move due to different factors. Although their price movements are never exact and totally predictable, there are certain tendencies which investors can reliably expect from them. And this is where currency correlation comes in.
Currency correlation is the statistical measure of the relationship between two currency pairs. The measurement is usually expressed in decimal value between -1 and +1, where a currency correlation value of +1 means that the two currency pairs move in the same direction 100% of the time, and a currency correlation of -1 means that the two currency pairs move in opposite directions 100% of the time.
Why does this happen?
Currencies are tied up with the nation/s using that particular currency. It is tied up to the economy and socio-political factors affecting the value of its money. And as such, nations are inter-related with each other. Therefore, a currency pair, which reflects the currencies of two nations, can be affected by multiple factors, whether internal or external, affecting several nations at any time.
Take the EUR/USD and USD/CHF as examples. These are two of the most inversely-correlated pairs in forex where the movement of one pair usually translates to the same movement of the other in the opposite direction. Some explain this as due to the close relation of Switzerland, which uses the CHF to the other European countries which use the Euro. Anything that affects the European countries which use the Euro must also affect Switzerland and its Franc. And with the currency pairs being opposites in terms of its base unit versus the US dollar, the two currency pairs are expected to be inversely correlated. With the Euro and the Franc moving in the same direction at the same time, whenever the EUR/USD (with EUR as the base currency) goes up, the USD/CHF (with the USD as the base currency) goes down.
Forex investors must also realize that the basic laws of supply and demand combined with the inter-relation of the different global currencies with each other, some correlations are bound and are expected to happen. Currency pairs move in dependence with each other.
For example, the GBP/JPY currency pair must somehow be related to the movements of the GBP/USD and the USD/JPY, where theoretically, one can derive the value of one from the other two.
So how exactly is currency correlation important in forex trading?
Currency correlation is important in the sense that an investor will be able to maximize profits and not contradict his own positions by knowing the correlations between the currency pairs. Again, using the EUR/USD and the USD/CHF as an example, it would be quite contradictory if a forex trader would buy both currency pairs hoping that both of them would move in the same direction. In the long run, they would just be canceling out since the two pairs are inversely correlated with each other.
Currency correlations can help forex traders in their trading decisions knowing that their analysis are backed up by the historical tendencies of the price movements of the different currency pairs.
