Currency Correlations: The Unexplored Potential in Portfolio Risk Management

An effective trader always cares about portfolio risk management. It is vital to clearly understand how your assets are sensitive to volatile markets. Mainly, this refers to trading Forex. This is where currency correlation can define future trading success.

While currencies are priced in pairs, every trade is dependent on another one. The key to success is to understand how FX correlation works and changes. It will give one a chance to define effective currency strategies as well as gain total control over the portfolio’s exposure.

In this article, we will discuss safe ways of investing in currencies and utilizing baseline steps for portfolio diversification.

Revealing the Essence of Currency Correlations

When experts say “correlation”, they mean statistically measured relations between two assets. Generally, traders use the correlation coefficient. It ranges between -1 and +1:

• A +1 correlation means that both currency pairs will follow the same direction 100% of the underlying period.
• A -1 correlation means that both assets will move the opposite way 100% of the time.
• A 0 correlation stands for the completely random relations between two Forex pairs.

So, what you need to understand is that the correlation between currency pairs is a measured relation between two assets.

The higher the coefficient, the more currencies are aligned. Different currency market correlations are used to predict asset rates as well as the direction they will move further. Traders can benefit even from a negative coefficient, as they can use it in hedging perspectives.

The potential of currency correlations for portfolio diversification

A successful trader foresees potential investment risks. Currency investments can be quite sensitive to market volatility. This is where effective portfolio management is essential. One of the correlation key factors is the ability to keep assets diversified.

For example, one can use several major currency pairs that are not correlated 100% positively like AUD/USD and EUR/USD. It means they can be used to diversify potential risks and still keep the core directional view.

Let’s say you establish a bearish outlook on the USD. It does not mean you need to purchase two lots of one pair, like EUR/USD. You can diversify your portfolio with one EUR/USD and one AUD/USD pair.

If you look for more diversification, you can use the imperfect correlation between asset pairs. It will let you reduce marginal risks. Additionally, traders can utilize different point values to their advantage. However, it is very important to consider effective currency risk management strategies.

Risk management strategies based on currency correlations

As stated earlier, correlation between currencies can be an effective tool to manage traders’ risks. The main idea is to understand how the two assets are connected. It may let them reduce the risk exposure and predict future rates.

For instance, one can take a long position on the EURO. At the same time, a trader opens a short position on USD. If the two currencies have a +1 correlation, they will move in the same direction. It means, investors will be exposed to risk. Oppositely, in case of a negative correlation of -1, a winning position will offset the potential loss.

Here are the 3 baseline steps to establish your investment optimization:

1. Diversification. It supposes investing in different currency pairs. The idea is to create a portfolio that does not depend on a single asset.
2. Hedging. Another way to use currency correlation to your advantage is to implement a risk-reduction strategy (hedging) that lets one offset one position with another. Let’s say, you are long on EUR and short on USD. The idea of hedging is to buy a put option on the EURO. If the currency value goes down, you will still feel safe.
3. Technical Analysis. Finally, traders can utilize technical indicators to identify trends and patterns for the potential price movement. With technical analysis, one can make more accurate decisions. Besides, it will give you a chance to see how the correlation changed over time. This data can also be used to predict next movements.

The key to success is to have a clear understanding of how traded currencies correlate.

Examples of successful investments using currency correlations

Making bet on correlations is possible during extreme market volatility. So, when discussing the biggest success stories, we should mention the Forex godfather George Soros. He was the one to achieve one of the most iconic deals in Forex exchange history.

Before “Black Wednesday”, Soros secured a profit of over £1 billion after going short on the pound sterling. It happened during the sustained economic volatility when the British currency crashed to hit its historic lows.

Moving Beyond Traditional Portfolio Management: Currency Correlations as a Competitive Advantage

Currency correlation is not something constant, It changes all the time. It means, your investment strategy should also be customizable and easy to transform when needed. We live in a world of dynamic economic factors and market sentiments.

One day you have strongly correlated currencies. Then, they will go off the line at some point with a negative correlation in the long-term perspective. Experts recommend considering a 6-month trailing correlation. It can deliver clearer perspectives on how the two currencies will behave. As a result, your predictions might be more accurate.

Risk and Reward: How to Balance Investments Based on Currency Correlations

Why does correlation change? Various reasons affect the process. They include monetary policy implemented by central banks, geopolitical situations, economic factors, and even commodity prices. Not to miss the pairing correlation strength and direction is to calculate it yourself. Traders can use a simple formula to compute correlations even for large input numbers.

When mastering the techniques of utilizing correlation, market participants can eliminate counterproductive trades, leverage profits, hedge and diversify potential risks. What’s more, the strategy helps to predict potential currency pairs’ rates, avoid fake outs, and confirm breakouts.