Correlation strategies appeal to forex traders because it removes the stress associated with picking market direction. When two correlated urban forex correlation scalping diverge from one another, the idea is to simply buy one pair and sell the other. Applying the idea to forex, it means that we need to pick two currency pairs. EURUSD and USDCHF are two popular choices due to their extremely high correlation, so we’ll use those.
EURUSD and USDCHF are so popular because they hold the strongest correlation among the major currency pairs. The European debt problems and Swiss National Bank’s intervention have a lot to do with the decrease in this number. Their trading relationships are far less stable. If you take the average over the past 20 bars, you know from experience that the average will differ if you study a 50 period versus a 200 period average. If you look at the average on a 5 minute chart versus an hourly chart, the number will vary yet again. The take-away here is that the correlations work the same way.
The correlation between EURUSD and USDCHF might even be positive if you look at a short enough time scale. As you back away in time, you will notice that the further out you go, the more steady the correlation numbers look. The same problem with the moving average also appears. Studying the correlation over 50 periods provides a responsive number, but it is also far less consistent than the 200 period correlation.
What a short period gains in responsiveness, it loses in stability. You should also consider whether the correlation that you’re studying makes fundamental sense. Just because the temperature change in Mongolia predicted the direction of USDJPY for the past week does not make it a good idea to use in the future. The same goes with pair trading. EURUSD and USDCHF should be highly correlated for two reasons. Additionally, the EUR and CHF both have strong trading relationships with the US.
You would expect both the Euro Zone and Switzerland to share a need for buying and selling US dollars. They need them for buying oil, importing and exporting to the US, etc. Correlation traders typically settle on pairs that share a common currency. The EURUSD and USDCHF trade both share the US dollar. Notice that the USD cancels itself out.
What you are really doing is buying EUR and selling CHF. This is commonly known as the EURCHF pair. Assuming that the spread is not outrageous, it makes more sense to simply buy or sell EURCHF directly rather than going through the convoluted process of managing two open trades. If you decide to pursue the two pair approach, you must consider the need to balance the trade sizes against each other. Using standard lots as the example, 100,000 EUR is 137,500 USD. Unless you intentionally decided to trade different sizes, you may want to consider equalizing them. It says absolutely nothing about the strength of a particular move.
A few months ago the USDCHF climbed 1,000 points in value within a single day. The EURUSD only moved a few hundred pips. The USDCHF moved dramatically further than the EURUSD both in terms of pips, but more importantly, as a percentage of price. Consider if you were short EURUSD that day and short USDCHF. You lost a ton of money. On the flip side, if you were long EURUSD and long USDCHF, then you got lucky and earned the move. Regardless of what happened, correlation told you nothing about the outcome when they move in the same direction.