Correlation refers to the behavior of two different currency pairs. Sometimes when looking at a chart, two currency pairs appear to have the same upwards and downwards movements. Look below at two well known correlation pairs: EURUSD and GBPUSD. The two images are very similar. They have a correlation value of almost +1.
The opposite of correlation is when two currency pairs move in opposite directions. EURUSD and USDCHF for example. The have a correlation value of almost -1.
Correlation values change over time, so it’s wise to frequently check the forex correlation tables for different currency pairs.
So how do we use this in our trading?
If two currency pairs moved exactly like one another, buying EURUSD and selling GBPUSD should result in 0 profits, and 0 losses (except for spread) regardless of the direction they moved. However, there are inconsistencies with their movements.
Sometimes, they don’t move together.
Below is a picture of GBPUSD and EURUSD charts put on top of each other. From this view, you can easily see points where they move in the same direction, and where they separate.
When they separate (low correlation), BUY the currency pair that has moved down, and SELL the currency pair that has moved up. When they come together again, close both trades. One trade will be in a profit. The other trade will be in a loss. Overall, the profitable trade should be bigger than the negative trade.
The risk with this trading strategy is that sometimes, currency pairs decide to break correlation for a long time before returning to the median.