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Trading Correlations in Risk Management

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Trading Correlations in Risk Management

In financial markets, asset correlation refers to the degree to which different assets’ prices change in relation to one another and the frequency with which such changes occur. 

The existence of correlations between the most extensively traded currency pairs and the most widely traded commodities in the world is not uncommon. For instance, because Canada exports a lot of oil, the Canadian dollar is positively correlated with oil prices, while the Japanese yen has a negative correlation with oil prices because Japan is a net oil importer. On the other hand, Australian and New Zealand dollars are highly correlated with gold and oil prices.

It’s also critical to realize that just because correlations appear to exist on average across time, it doesn’t guarantee they do so consistently. One year a pair of currencies or assets may be highly connected, but the next year they may diverge and exhibit a negative relationship. As a trader, you need to be aware of periods when the link between different assets is strong, when they weaken or when the relationship changes.

Types of correlation

When determining the level of correlation, the historical performance of the assets is used to calculate a percentage value. This is presented on a scale ranging from -100 percent to 100 percent.

Correlations can be classified into three categories.

  • There is a positive correlation when the price of two assets rises or falls at the same time. This correlation might be strong or weak. If two assets have a 30% correlation, it means that historically, when the value of one of the assets rose or fell, the value of the linked asset rose or fell in the same direction, roughly 30% of the time.

It’s important to remember that when you trade two pairs with high positive correlations, your risk is multiplied by two, which, for example, translates to a potential loss of 2% if you had taken the risk of 1% for each position. 

  • The correlation is said to be negative if the price of one asset falls while the price of another rises.

So, if you see a number like -70 percent, it implies a review of historical data shows that the assets have moved against each other at least 70 percent of the time in the market.

  • Zero correlation: This signifies that the prices of the assets are absolutely unconnected to one another. One asset’s price fluctuation will have no impact on the other’s.

The significance of correlations

Correlations act against diversification that can have a major influence on your total risk and profit, as one market going against you can have an impact on a large chunk of your portfolio.

This means if you have open two long positions on different assets that are 80% correlated, you can expect a bullish move by one asset to be followed by a similar movement in the other. 

However, if one of the positions moves against you, you could lose all of the money you have invested. As a result, the overall risk of the deal may be more than you anticipated.

If you hold a number of investments in closely connected assets, your overall portfolio risk may be much larger than you realize. You should always do your due diligence to see which markets are related and which can help you diversify your holdings and income streams.

Risk management based on correlation

If you’re using this risk management strategy, keep the items below in mind.

Try to limit the number of positions you open so that they don’t overlap.

  • In the case of the ZARGBP and the GBPJPY, for example, you can expect both currency pairs to move in opposing directions, which would lead to the trades balancing each other.

The reason for this is that the GBP is utilized twice: as a base currency in GBPJPY and once as a quote currency in ZARGBP. If the GBP strengthens versus the other currencies, the ZARGBP will fall while the GBPJPY would rise, with the change in one exchange rate balancing out the change in the other.

Do not open new positions using the same base currency as the one used as the quote currency.

  • Take an instance where a trader goes long on CADUSD, JPYUSD, and GBPUSD. Because all three of these currency pairs share the same quote currency, the US dollar, we expect their price movements to be positively correlated. The trader will therefore experience great losses when the USD strengthens or make large profits if the greenback weakens. 

Remember to keep an eye out for commodities currencies.

  • A commodity currency is one whose value fluctuates in accordance with the price of a particular commodity that is that country’s primary export.
  • In general, if commodity prices rise, the currencies of commodity producers will follow suit, and the reverse is also true. For example, the South African rand is closely linked to the price of gold, while the Australian dollar is largely dependent on iron ore prices.

Another thing to think about is diversification.

  • Since currency pairs hardly have a 100% positive correlation; traders can utilize them to spread their risk while keeping a directional bias.

In summary

Trading several currency pairs necessitates an understanding of the positive and negative connections that exist between them. To avoid taking on too much risk is the most important factor. The key to reducing risk is to have a well-diversified portfolio.

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