How to Calculate Currency Correlations Yourself

If you've been involved in forex trading for a bit, you've likely noticed certain currency pairs move together while others seem to act in completely opposite directions. That is not just happenstance, it is correlation, and understanding these relationships is one thing, but developing the ability to calculate the correlation yourself gives you another layer of control rather than relying on someone else’s table or outdated data. 

The good news is you don’t have to be a mathematician! With some data and simple tools, anyone can do it! 

What is correlation in trading?

Correlation is simply a measure of the extent to which two things move in relation to each other. In forex, it is a measure of how well two currency pairs move together. 

• A correlation of +1.00 indicates they move perfectly together. 

• A correlation of -1.00 indicates they move in opposite directions. 

• A correlation of around 0 indicates there is little or no consistent link. 

For a trader, knowing these numbers can help avoid “double risk,” determine whether to hedge, and verify a larger market correlation. 

Step 1: Gather the data

To begin we will require comparing pairs, for this instance let’s use the EUR/USD and GBP/USD pairs.  With these two currency pairs you will require their historical price for a fixed time period, say last 30 or 90 days. The daily close price works well but should you be a shorter term or longer term trader feel free to play around with the time frame.This information is readily available from your broker's platform or free financial websites. 

Step 2: Calculate Returns 

Raw prices do not provide the whole picture. What you need is the percentage change from day to day, which is called returns. This makes the price movement comparable so that you can directly compare two pairs. 

For instance, if EUR/USD was 1,1000 and the next day it was 1,1050, the currency has gone up around 0.45 percent. You will repeat this calculation for each day in your chosen time period for both pairs. 

Step 3: Run the Correlation 

Now we get to the fun part: calculating the actual correlations themselves. This is typically done using an indicator called the Pearson correlation coefficient. Don't let this name alarm you - it is simply a formula that compares how two sets of numbers move together. 

If you are using Excel or Google sheets, you wouldn't even need the formula, simply run the function as follows: =CORREL(range1, range2) 

Where "range1" will be your list of each of the daily returns you calculated for EUR/USD and "range2" is the daily returns calculated for GBP/USD. Simply hit enter, and as if by magic you will be presented with a single number ranging from -1 to +1. 

A Quick Example 

Let’s say you calculate EUR/USD vs GBP/USD over 90 days and the correlation works out to +0.88. This indicates strong positive correlation, in that they primarily move in the same direction. If you had both long, you would not be diversifying, but would in fact be doubling your exposure to the dollar. 

Now lets compare EUR/USD against USD/CHF and perhaps you get a result of -0.91. In this case you have a strong negative correlation, indicating that they primarily move in opposite directions.  With both long, you would have a natural hedge in the event that either pair moves against you. 

Interpreting the Results 

Here is a relatively simple range of values to help your interpretation of correlation values of +1 to -1: 

This “cheat sheet” provides users with a simple way to assess if the correlation of their trades leaves them overly exposed to currency risk or nicely balanced. 

Common Missteps to Avoid 

In working with correlation data, or trading correlations for that matter, traders invariably fall into the same trap: 

- Outdated data. Just like that any correlation can change with new economic events coming into play. Nothing wrong with getting a fresh calculation that is more indicative of the current state of the market. 

- Secondly don’t forget about timeframes. A pair may look very strong on a daily correlation basis, but looking over several months it may appear weak. Be sure to match the correlation timeframe to your trading suitcase. 

- Finally, do not anticipate perfection. While a correlation of +0.95 feels fairly correlated it is not realistic to be predictable every time they trade together. The market can remain quite unpredictable at times. 

Conclusion 

Calculating correlations is not hard to do in fact it gives traders an independent way of assessing if your trades are independent opportunities or simply two ways of making the same bet. You may even stumble upon using one or the other pair as a natural hedge to reduce your exposure. 

If you create the habit of confirming correlations you will begin the process of trading smarter and not harder, and for those interested in other methods of applying this knowledge to real trading strategies, check out the Learn section in Wikilix, and where the process of linking concepts like correlation into tools you can use in the market.