As a forex trader, if you check several different currency pairs to find the trade setups, you should be aware of the currency pairs correlation, because of two main reasons:
1- You avoid taking the same position with several correlated currency pairs at the same time and so you do not increase your risk. Additionally, you avoid taking opposite positions with the currency pairs that move against each other, at the same time.
In both of the first two currency pairs (EURUSD and GBPUSD), USD works as the money. As you know, the first currency in currency pairs is known as the commodity and the second one is the money. So when you buy EURUSD, it means you pay USD to buy Euro. In EURUSD and GBPUSD, the currency that works as the money is the same (USD). The commodity of these pairs are both related to two big European economies. These two currencies are highly connected and related to each other and in 99% of the cases they move on the same direction and form the same buy/sell signals. Just recently, because of the economy crisis, they moved a little differently but their main bias is still the same.
What does it mean? It means if EURUSD shows a buy signal, GBPUSD should also show a buy signal with minor differences in the strength and shape of the signal. If you analyze the market and you come to this conclusion that you should go short with EURUSD, and at the same time you decided to go long with GBPUSD, it means something is wrong with your analysis, and you are wrong at least with one of your decisions. So you should not take any position until you see the same signal in both of these pairs. Of course, when these pairs really show two different directions (which rarely happens), it will be a signal to trade EUR-GBP. I will tell you how.
Accordingly, USD-CHF and USDJPY behave so similar, but not as similar as EURUSD and GBPUSD, because in USDCHF and USDJPY, money is different. Swiss Franc and Japanese Yen have some similarities because both of them belong to oil consumer countries, but the volume of industrial trades in Japan, makes JPY different compared to CHF.
Generally, when you analyze the four major currency pairs, if you see buy signals in EURUSD and GBPUSD, you should see sell signals in USDJPY. If you also see a sell signal in USDCHF too, then your analysis is more reliable. Otherwise, you have to revise and redo your analysis, or at least wait for another trade setup.
What do I prefer?
If I find a sell signal with EURUSD and GBPUSD and a buy signal with USDJPY, I prefer to take the short position with one of the EURUSD or GBPUSD because downward movements are usually stronger. I will not take the short position with EURUSD or GBPUSD and the long position with USDJPY at the same time, because if any of these positions goes against me, the other one will do the same. So I don’t double my risk by taking two opposite positions with two currency pairs that move against each other.
How to use the currency pairs correlation to predict the direction of the market?
When there is a signal formed with a pair that have to be confirmed to form a trade setup, I refer to the correlated currency pairs or cross currency pairs and look for the confirmation. For example I see a MACD Divergence in USDCAD four hours chart, but there is no close support breakout in USDCAD four hours or one hour chart. I want to take a short position, but I just need a confirmation. If I wait for the confirmation, it can become too late and I may miss the chance. I check a correlated currency pair like USDSGD and if I see a support breakout in it, I take the short position with USDCAD. Now the question is why I don’t take the short position with USDSGD and I use its support breakout to go short with USDCAD? I do it because USDCAD movements are stronger and more profitable. I use USDSGD just as an indicator to trade USDCAD.
It happens that you take a position with a currency pair, but it doesn’t work properly and you don’t know if it was a good decision or not. On the other hand, you don’t see any sharp signal on that currency pair to help you decide if you want to keep the position or close it. In such cases, you can check a correlated currency pair and look for a continuation or reversal signal. It helps you decide about the position you have.
Sometimes, some correlated currency pairs don’t move the way they are supposed to. For example EURUSD and USDJPY go up at the same time, whereas they usually move against each other. It can happen when Euro value goes up and USD value doesn’t have a significant change, but at the same time JPY value goes down, for some reason. In these cases, you can use the below table to find and trade the currency pair that its movement is intensified by an unusual movement in two other currency pairs. In this example, if EURUSD and USDJPY go up at the same time, EURJPY will go up much stronger (see the below chart).
Or if EURUSD goes up and AUDUSD goes down at the same time, EUR/AUD goes up strongly.
Another important example: If EURUSD goes up and GBPUSD goes down at the same time, EURGBP goes up strongly. Maybe this is the most important case that we can trade based on this rule. It happens many times that EURUSD and GBPUSD move against each other and that is the best time to trade EURGBP. Now you know why EURGBP doesn’t move strongly most of the time. It is because EURUSD and GBPUSD move in the same direction most of the time. For example they go up at the same time and so EURGBP doesn’t show any significant movement, because when both of the currencies of a currency pair go up or down at the same time, that currency pair doesn’t show any strong movement and direction (I hope you know why a currency pair goes up or down. It goes up when the first currency’s value goes up OR the second currency’s value goes down. For example EURUSD goes up, if Euro value goes up or USD value goes down. If this happens at the same time, then EURUSD goes up much stronger).
The below chart includes almost all of these unusual movements and their impact on the third currency pair.