Avoiding Double Risk with Correlated Pairs

A common trading mistake in forex is to incorrectly think you are "diversifying" when in fact you are simply increasing your exposure. This is especially relevant when you are trading pairs that are too closely correlated. Looking logically at positions you hold in a respective trade may lead you to believe you are diversifying that risk exposure. The fact is you've compounded that risk exposure to the same position.

Understanding how correlations work, and what you can do with them, can stop you from making the same mistake.

What is double risk?

Double risk is when two (or more) trades are dependent on the same outcome. For example, you are a buyer of the EUR/USD currency pair because you believe the euro will gain strength. You also happen to be a buyer of GBP/USD, because you are optimistic about the pound. In your mind, you now have two individual trades.

However, both trades depend on a weaker US dollar. If your concern were to happen and the US dollar gained strength then you were to lose on both trades. This is what is called double risk; you had two trades in the same direction for the same reasoning.

Correlation matters

Currency pairs do not move or act in a vacuum. They are correlated because they are either part of the economy or commodities, or there is a global trend that will cause both currencies to ultimately act a certain way. This causes traders to start thinking about correlation values or how closely correlated two currency pairs would move together.

Positive correlation (+1.00) typically means the currency pairs will move in the same direction.

Negative correlation (-1.00) typically means the currency pairs will move in the opposite directions.

Correlation near zero typically means that there is little to no relationship. 

You can quickly see if you have inadvertently got into the same position by looking at the correlation values.

A simple example

Let's say you take the long position of EUR/USD and also buy GBP/USD long. Assuming a correlation of +0.90 between the two pairs means they generally move in nearly perfect coordination. You've effectively doubled your bet on a declining US dollar.

Now, let's say you decide to operate the EUR/USD long, and to maintain a USD bias, you short USD/CHF. These two pairs usually have negative correlation with one another. In this case, you could argue that one position will help compensate for the other position's loss in a way that reduces your overall risk.

Reading correlations in practice

Here's a simple table to keep in mind:

Don't think of it as memorization—it's more about understanding when two trades are actually one trade presented in two different pairs. 

Mistakes traders often make

One trap I see most traders fall into is having the thought that correlations don't vary/change. Well the truth is they do. Changes from central bank actions, interest rates, and even global catastrophes can turn relationships upside down. A pair that has been stuck to a relationship either positively or negatively can suddenly start to drift away.

Another common error is considering your pairs when evaluating on a shorter timeframe. For example; On the daily chart, if you see two pairs have a strong correlation, however over a period of a month you think it's weak then that could be a valid point of consideration. Be sure to align with your trading style.

How to mitigate double risk

Here are two simple methods that can help you to protect yourself:

An easy way would be to simply check the correlation before trading more than 1 transaction. You could simply glance at a correlation table, roughly re-adjusting your thinking as you add pair(s) but aware of whether you added the same transaction twice potentially. 

You could physical hedge your exposure. Instead of having the burden of lots of highly positively correlated pairs, simply trade the opposite order assuming you in-tend to risk manage your exposure somewhat. Ultimately your exposure is balanced since you have bought and sold. 

This doesn't imply you can never trade pairs together—It mainly infers that you must consistent be mindful of each arrangement you're adding to your risk profile. 

Conclusion

Avoiding double risking is all about awareness. A pair or trade arrangement that at the time may not appear to be relative could be on a similar pattern without realizing its origin. Check your currents correlations and utilize them before draping yourself into more potential risk exposure.

By taking note of pairs that correlate or are separating, you can manage your exposure check your by markets risk, potentially arrange some sort of hedge if applicable and confidence hopefully increases with experience.

If you want even more posters and examples; just look at the learn section on Wikilix and start turning your knowledge into habits in reference to protecting your trading capital and skills.