Always Know How Much You Are at Risk

Always Know Your Risk Exposure

When trading multiple currency pairs, it’s crucial to assess your level of risk. You might think that by trading different pairs, you are diversifying your risk. However, if these pairs tend to move in the same direction, you could actually be doubling your exposure.

Understanding Currency Pair Correlations

Let’s examine an example of two highly correlated pairs and how they behave over a week: EUR/USD and GBP/USD.

Period	EUR/USD	USD/JPY	USD/CHF	GBP/USD	USD/CAD	AUD/USD	NZD/USD	EUR/JPY	EUR/GBP
1 week	-0.23	-1.00	0.94	-0.98	0.98	0.93	0.93	0.86
1 month	0.63	-0.98	0.13	-0.90	0.90	0.96	0.91	0.86
3 months	-0.62	-0.92	0.83	0.14	0.63	0.42	0.61	0.75
6 months	-0.62	-0.85	0.31	-0.35	0.61	0.65	0.28	0.71
1 year	-0.69	-0.98	0.88	-0.93	0.95	0.96	0.66	0.02

What Does High Correlation Mean?

EUR/USD and GBP/USD have a strong positive correlation of 0.94, meaning they almost always move together. Trading both pairs at the same time is equivalent to doubling your position on a single pair.

If you go long on both EUR/USD and GBP/USD, you are essentially betting on the rise of the euro and the pound against the US dollar. But what happens if EUR/USD starts falling? GBP/USD will likely follow, and now both your trades are in the red.

Some traders mistakenly believe that profits from one pair can offset losses from another. However, this is not the case because:

• Different Pip Values: The pip value of EUR/USD and GBP/USD is not the same, leading to imbalance in profits and losses.
• Different Volatility: If EUR/USD moves 200 pips, but GBP/USD only moves 190 pips, your short trade on GBP/USD could eat into your profits from EUR/USD.
• Independent Market Factors: A news event impacting the euro may not have the same effect on the British pound.

Opposite Correlations and Their Pitfalls

Now, let’s analyze another example: EUR/USD and USD/CHF. These two pairs are almost perfectly inversely correlated (-1.00).

If EUR/USD goes up, USD/CHF almost always falls—they are like day and night, fire and water, Batman and the Joker.

How Does This Affect Trading?

If you go long on EUR/USD and short on USD/CHF, you are doubling your exposure on the euro against the US dollar. This might seem like a good hedge, but in reality:

• If EUR/USD drops suddenly, both trades could turn into losses.
• The volatility of each pair can be different, leading to unpredictable outcomes.
• Spread costs and pip differences can eat into your profits.

Thus, trading opposite correlation pairs at the same time may not be a good strategy. Even though EUR/USD and USD/CHF move in opposite directions, their movements might cancel each other out, leaving you with minimal profit—or worse, a loss.

How to Use Correlation to Your Advantage

1. Avoid Doubling Your Risk

If two pairs are highly correlated, avoid opening positions in both at the same time, as you are doubling your exposure rather than diversifying.

2. Don’t Hedge Trades Unnecessarily

If two pairs move in opposite directions, trading them simultaneously might neutralize your profits. Instead, choose one and stick to a clear trading plan.

3. Use Correlation as Confirmation

Before entering a trade, check how related pairs are moving. If EUR/USD is rising but GBP/USD is not following, reconsider your trade and look for more confirmation before entering.

Key Takeaways

• Trading two highly correlated pairs is like placing the same trade twice, increasing your risk.
• Oppositely correlated pairs may cancel each other out, limiting potential profits.
• Using correlation analysis can help confirm trade signals and improve risk management.

 

Manage your trades wisely, minimize unnecessary risks, and use currency correlations to enhance your strategy! 🚀