US Dollar Guru (Part II)

Knowing currency correlations between the major pairs can help you a lot in your trading. Suppose you have the data about the currency correlations of the major currency pairs. The correlation between GBP/USD and EUR/USD is 0.68. This correlation coefficient is positive and it means both the pairs move in the same direction 68% of the time.

USD/CHF and EUR/USD have a correlation coefficient of -0.975 and is pretty close to minus one. The negative correlation coefficient means both USD/CHF and EUR/USD pairs move in the opposite direction almost 97.5% of the time. In other words, if USD/CHF moves up, the pair EUR/USD will move down!

You have this information that tells you how much these pairs move in the same or opposite directions. You trade the pairs USD/CHF and EUR/USD at the same time by going long on both. You are in fact canceling both the positions.

If you win on USD/CHF, you will lose on EUR/USD and vice versa. The two trades would effectively cancel each other due to the negative correlation between the two pairs. A savvy investor would go long on USD/CHF and go short on EUR/USD. So you are shorting USD in both the trades and diversifying the USD bearish investment.

You can make trade entry and exit decisions based on currency correlations. Suppose GBP/USD starts showing volatility and approaches a resistance level. You anticipate going long on a breakout.

However, you notice that the other three pairs are not moving as much as the GBP/USD. EUR/USD is not moving up. USD/CHF is not moving down. USD/JPY is not moving down. This means that the move in GBP/USD is solely pound driven related to some news in the British economy.

Now you know that the move in GBP/USD pair is Pound driven and not US Dollar driven. You can take advantage of this information by ignoring the GBP driven move and waiting for a later opportunity that involves simultaneous correlated moves of all the major pairs.

Lets take another example to make things more clear. Suppose you have taken a short position on EUR/USD currency pair. You want to know will the currency pair proceed down towards your profit target. You also want to know can it go against you. If so when to exit the trade with a small loss!

Your EUR/USD has broken the S1 support pivot level and heading towards M1. By looking at the pair EUR/GBP, you find that it has paused at its S1 support pivot level and is showing signs of reversing to the upside.

Knowledge of currency correlations can tell you if EUR/GBP breaks through the S1 level, you are poised for a profitable trade in this type of a situation, However, you should watch the indicators and exit before taking a big loss if it reverses and heads back to the upside. You might consider trading a basket of all the major currencies as you mature in forex trading.