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Using The Correlation Matrix To Trade Like An FX Dealer

by Jun 16, 2021Trading Guides

The FX market is immense. There are seven major FX pairs and over 70 crosses! How can one person possibly keep track of everything and identify the best pairs to trade at any given time? That’s where the correlation matrix can come in handy.

Most traders, when exposed to the word “correlation”, automatically think of intermarket analysis.

For example:

  • Gold is directly correlated to silver and inversely correlated to the USD.
  • AUD and NZD are directly correlated.
  • EURUSD and USDCHF are inversely correlated.
  • Stocks and bonds are inversely correlated, etc…

 

Setting Up Your FX Correlation Matrix

It is very easy to manually determine a correlation matrix in MT4 and MT5.

  1. Select your currency pairs to compare.
  2. Select the time frame based on your trading style:
  • Medium to long-term traders might want to use the daily time frame with a 25-bar lookback period.
  • Swing traders might want to use the 4H time frame with a 100-bar lookback period.
  • Day traders might want to use the 10-minute time frame with a 100-bar lookback period.

Of course, these are only suggestions. The key is to select a time frame and a lookback period that compliments your trading style and commit to it.

  1. Highlight the strong correlations that are visible. Identify which pairs are either moving strongly in lockstep or strongly opposite one another.
  2. Determine what market event is enacting a similar influence over the different currency pairs.

 

correlation matrix

 

Alternatively, custom indicators can be added to your account to do some of the heavy lifting for you.

 

Tracking Common FX Themes

When all the crosses of a currency pair are moving in the same direction, there is usually a fundamental reason. Even if you don’t know the fundamental cause, you can still identify the overwhelming dynamic and keep that currency pair on your watch list.

 

Using Correlations To Allocate Risk

When correlations are high, you can spread your risk capital amongst two or three different FX pairs. This way, you reduce the risk of identifying the market drivers correctly but on the wrong instrument. We will never know ahead of time which pair will be “the winning horse”. Consequently, when there is a strong correlation amongst crosses, splitting our risk allocation amongst two or three candidates makes more sense. We can then ride the winning horse and reduce risk on the slower performers.

It’s already difficult enough to identify clear drivers and strong themes in the currency markets. If we think we’re good enough to pick the best currency every time, we fall into yet another mental bias that will harm us more than help us. So, instead of risking, say 2%, on one single currency pair, try risking 0.5% on three pairs. As a result, one of them might develop into the multi-day trend trade we all aspire to catch.

 

What’s Next?

The correlation matrix is a very neat tool that allows us to spot strong FX correlations amongst the major pairs quickly and amongst the crosses of a given regional currency.

You should attempt to:

  1. Identify the situations that show high correlation amongst pairs.
  2. Track them back to the fundamental influences that are driving the correlation.

If you take these simple steps, you will be in an ideal situation. You will understand why the currencies are behaving the way they behave, and you will be able to make sense of the technical behaviour on your charts.

It’s like boxing with both arms (technical and fundamental) instead of just one (technical).

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