The importance of correlation in hedging

May 26, 2019
7 Comments

Definition:

Knowing the definition of correlation can be very helpful in FX trading.

Correlation is a mutual relationship or connection between two or more pairs.
The value of a correlation coefficient ranges between -1 and 1.
The greater the absolute value of the correlation coefficient, the stronger the linear relationship will be.
The strongest linear relationship is indicated by a correlation coefficient of -1 or 1.
A positive correlation means that if one pair’s price rises the other pair tends to rise and vice versa.
A negative correlation means that if the price of one pair rises, the other pair’s price will fall.

Use of correlation in hedging:

Hedge traders use pairs with correlations to hedge fund against each other. This means that they open two positions which have a good absolute correlation at the same time.

This will reduce the risk but also reduce your chances of gaining more profit.

You can’t find pairs with 100% absolute correlation. But there are many pairs with correlation very close to 100% (-1 or 1). If the correlation is high (normally above 80) and positive then the currencies move in the same way. If the correlation is high (normally above 80) and negative then the currencies move in the opposite way.
  • Use of pairs with positive correlation:
If you want to use pairs with positive correlation for hedging, you should by a pair and sell the other pair.
  • Pairs with negative correlation:
To get the advantage of hedging using pairs with negative correlation, simply buy or sell both pairs. This means if one pair goes up the other will goes down. 

Some of the pairs with negative correlations:
This may change, so always check the recent data and graphs.
#EURUSD – #USDCHF

Some of the pairs with positive correlations:
#EURUSD – #GBPUSD
#AUDUSD – #EURUSD

#GOLD and #OIL

Gold and Oil’s correlation is different from the FX pairs.
Gold and Oil normally have a good positive correlation on longer timeframes like weekly time frames. The reason is that investors are looking at Gold as a safe haven in financial crises.

There is a reliable scenario: If the price of Oil goes high, the inflation goes high. During the high inflation, investors tend to invest more in Gold. This will cause the gold price to rise.

In shorter time frames we can not see any correlation between these 2 though. You may notice during a period of time they have negative correlation and on some other days no correlation at all.



Risk management

If a trader doesn’t know the correlation he or she may increase the risk. Imagine someone opens 2 buy positions with 2 pairs which have a positive correlation. This means if one pair hits the stop loss the other pair also may hit the SL.

The stop-losses are an important tool in Forex trading to limit losses. You simply can’t be successful in the long run if you don’t limit your downside by using stop losses.
The hedging strategies work the same way like a stop loss order in terms of limiting losses. However, the advantage of hedging is that you can also make money on the hedge trade depending on the second trade selection. However, you need to take into account the carry on costs of leaving a trade open for a long time.