Currency correlation refers to the sensitivity of a position to market volatility. In this context, correlation is the measure of the relationship between the two currency pairs. Some of these pairs move together while others move in the opposing direction.
A strong correlation implies that when one of the currency pairs rallies, so does the other. For example, if EUR/USD and GBP/USD have a strong correlation of 0.95, then a move in one should mimic a step in the other. However, these correlations change over time.
The hedging strategy comes from understanding the relationship between the position you wish to hedge with its correlated counterparts.
Since this strategy only involves forex transactions, it is suitable for all investors.
A hedge based on currency correlations can provide sufficient protection from market movements.
Low to Moderate
In terms of cost, this strategy is the same as any other forex transaction.
Using the fictitious correlation table below, find the currency pairs most closely related to EUR/USD.
If you answered EUR/USD with GBP/USD, you are correct. The positive correlation of 0.95 is excellent. This result means that GBP/USD will mirror a move in EUR/USD 95% of the time. One caveat is during the six-month mark, where the correlation dropped to 0.66. However, over one year, the two currency pairs exhibit an obvious correlation.
As a hedge, you could enter a position with a negatively correlated currency pair to simulate a short, among many other strategies. Regardless, understanding currency correlations will make you a better forex trader.
© 2020 Todd Moses
The strategies discussed are for illustrative and educational purposes and are not a recommendation, offer, or solicitation to buy or sell any currency or to adopt any investment strategy. There is no guarantee that any strategies discussed will be useful. Todd Moses is not a licensed securities dealer, broker, or US investment adviser or investment bank.