Why such strong correlation of pairs? | Forex Factory

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Why such strong correlation of pairs?

  • #1
  • First Post: Edited 8:03am Oct 13, 2011 3:56am | Edited 8:03am
This isn't as simple a question as it first appears. I am struggling to understand why individual currencies behave almost identically on all their pair crosses at exactly the same time.

For example, when the EUR is weakening, it will drop simultaneously against the USD, CHF, JPY, GBP etc. On the face of it this seems perfectly obvious, but with a little more thought, I just can't understand the reason or the mechanics behind it.

As we all know, the selling of one currency is only done by the buying of another. It's a true exchange of one for the other, and exchanging currencies electronically is no different to doing it physically at your local bank or Bureau de change. If I determine that the EUR is getting less valuable, I would want to sell it and exchange it for something of more value (preferably of the greatest value). If I was to do this in my local bank, I would not walk in with my Euro's and ask to exchange them for GBP, and USD, and CHF, and JPY etc, not least because any one of those other currencies may be of even less value than my Euro's.

So why does the EUR strengthen or weaken simultaneously against all the other currencies? This is particularly evident when watching very short term time frames. If there is a sudden 20-30 pip move involving the EUR over a 2 minute period, the same move will show up on every pair which includes the EUR. Why? How does that happen?

Is someone actually buying or selling the same currency in exchange for any and every other currency they can get their hands on? If so what would be the logic for this action? Or is it a case of the main liquidity providers simultaneously removing their BID's or OFFER's from the market for some reason? (contrary to popular belief, prices can move on your chart without any buying or selling taking place).

I can understand the correlation over the longer term as governed by economic sentiment, but I can't understand it in the supposed "noise" at the shorter term. The apparently "random" fluctuations and spikes will happen almost identically on every single pair involving the same currency, and for the life of me, I cant figure out why this would happen. Why would "noise" happen at the same time on every pair? That 10 second spike up and then immediately back down again happens on every EUR pair - that isn't random; it has to be coordinated in some form or another.

Any help from someone with more in-depth market knowledge than me would be greatly appreciated.
  • #2
  • Oct 13, 2011 5:11am Oct 13, 2011 5:11am
I'm not sure what you are really asking, but if your asking why if the EUR fluctuates.. it moves it's other cross pairs.. this is because each currency has a Trade weighted Index. If you are interested you should google TWI or trade weighted index
  • #3
  • Oct 13, 2011 5:36am Oct 13, 2011 5:36am
Quoting ishii1
I'm not sure what you are really asking, but if your asking why if the EUR fluctuates.. it moves it's other cross pairs.. this is because each currency has a Trade weighted Index. If you are interested you should google TWI or trade weighted index
I think this is precisely what I've been looking for, thank you.

I'm amazed at my own naivety and lack of knowledge sometimes. I'm trading for a living in a market that I clearly do not really understand other than at the most superficial level.

So am I correct in concluding that when there is heavy selling of EUR in exchange for USD (real transactions and exchange of currencies one for the other), the price reflected on a chart of the EURJPY will similarly change due to the automatic re-adjustment of the weighted index for the Yen's relationship with the EUR, and this fluctuation in price is based on a change in the BID's and OFFER's in the auction, rather than any significant volume of actual buying and selling of Euro or Yen? Effectively the banks are automatically changing their exchange rate of EURJPY to reflect the change in the EURUSD relationship, and they do this regardless of the supply and demand for the EURJPY at the time?
  • #4
  • Oct 13, 2011 5:57am Oct 13, 2011 5:57am
ok ok this is how it works.. when you go long in EUR/JPY for example.. you arent buying EUR to the pound or a currency 'EUR/JPY you are just buying EUR.. when you short.. you are ONLY buying JPY hence why there is a correlation. so pairs such as aud/usd.. if you go long and sell.. it means you bought aud and sell.. exchanging it for usd. if you notice on your live account there will be a pip cost. e.g. when using 10,000 the current pip cost is 0.98 for aud/usd (using AUD as base currency)

sorry if i didnt explain it clearly
  • #5
  • Oct 13, 2011 5:58am Oct 13, 2011 5:58am
i meant euro to the yen
  • #6
  • Oct 13, 2011 6:06am Oct 13, 2011 6:06am
Quoting flotsom
This isn't as simple a question as it first appears. I am struggling to understand why individual currencies behave almost identically on all their pair crosses at exactly the same time.

For example, when the EUR is weakening, it will drop simultaneously against the USD, CHF, JPY, GBP etc. On the face of it this seems perfectly obvious, but with a little more thought, I just can't understand the reason or the mechanics behind it.

As we all know, the selling of one currency is only done by the buying of another. It's a true exchange of one for...
Broad correlation such as this is more an indication of the selling off/buying of the Euro specifically. These tend to be good times to trade.
The road to pipland is arduous and fraught with challenge.
  • #7
  • Oct 13, 2011 6:24am Oct 13, 2011 6:24am
I think I may be coming across a little too naive as if I have no grasp of the basics. I actually think my question is a little more deep that may appear at first glance.

I realise that when I buy EURJPY, I am not having any direct relationship or interaction with GBP or any other currency directly. I am buying EUR and selling JPY to do so. The buying and selling of one currency against another is very straight forward.

What I'm trying to understand is why (or more importantly how) selling/buying on one pair would impact another pair.

If I was a major player and I sold 1 Billion Euro in exchange for Yen causing a fast drop in the EURJPY price as I consume the available BID's in the market, why would the EURUSD price also immediately drop significantly when I didn't touch that pair? Does this make more sense as to my question?

There is no major selling of EUR against the USD, and yet the EURUSD pair would most certainly drop in unison with the EURJPY. This is the correlation I am trying to understand. Prices are moving without any buying or selling taking place. I guessed this was the case, but didn't know why, and the purpose of this thread was to learn more about the relationship and calculations for setting exchange rates across the board, and how each individual currency influences the others.

Based on reading about the Trade Weighted Index, I think I am starting to understand it more now. When there is a change in the exchange rate of one currency pair (one economy against another), the liquidity providers automatically factor that in to their BID's and OFFER's on other pairs which are assessed on this "weighted" calculation. As the weighted value adjusts, so to do the BID's and OFFER's the banks put out in to the market for other pairs, and hence the available price on the EURUSD and all other EUR pairs will adjust rapidly in unison with the EURJPY. So even though the heavy selling only took place on one pair (actual buying/selling transactions moved the market in EURJPY), the other pairs also moved based purely on the adjustment of BID's and OFFER's in the auction, without any significant transactions taking place.

This intertwined relationship measured with the weighted index explains so much that I was in the dark about previously.
  • #8
  • Oct 13, 2011 6:32am Oct 13, 2011 6:32am
"why it would affect another". because if you buy the EUR agaisnt the pound you are actually buying the EUR currency itself and ONLY the EUR meaning.. more demand for the EUR regardless of which cross pair the price will go up therefor there will be an upwards movement in the other EUR crosspairs
  • #9
  • Oct 13, 2011 6:47am Oct 13, 2011 6:47am
Quoting ishii1
"why it would affect another". because if you buy the EUR agaisnt the pound you are actually buying the EUR currency itself and ONLY the EUR meaning.. more demand for the EUR regardless of which cross pair the price will go up therefor there will be an upwards movement in the other EUR crosspairs
I may be about to come unstuck here and have to go back to the drawing board for everything I ever thought I knew about trading currencies.........but I think you are 100% wrong here.

If I buy the EUR against the GBP, I am not only buying the EUR, I am simultaneously selling GBP. I am effectively selling GBP in order to pay for the EUR I want to buy. This is the whole purpose of having currency "pairs": I am exchanging one for the other. If I was only buying EUR as a sole entity, there would be no need for pairs, we would just trade a EUR index. Let's not forget the Forex market was established primarily to facilitate commerce, and nothing to do with speculators.

If I walk in to my local Bank branch and ask to buy EUR, they will expect me to pay for it with something, and whatever I am paying for it with, is the currency I am selling.

When I am buying the EURGBP it is a straight transaction between those two currencies, and on that basis should not impact any other pairs.....but it clearly does, and this is what I have been trying to figure out which I believe I now have thanks to you pointing me in the direction of the Trade Weighted Index.

I'm not questioning why there is a relationship between currencies and correlation between different pairs. I am asking "how" this happens. What is the mechanics of it?, and I believe the Trade Weighted Index answers that question for me.

When one pair experiences heavy buying or selling, the other pairs will also experience and change in price, even though no buying or selling took place directly between those other pairs. I knew this was happening but did not understand "how" or on what basis it happened. I think I understand more clearly now, and with more study about the workings of the weighted indexes, I'm sure my understanding will only improve.
  • #10
  • Oct 13, 2011 6:52am Oct 13, 2011 6:52am
If you sold Euro for the yen, $3231b in volume for example.. the price in EUR/USD would not drop it would go up because you sold EUR..meaning someone else has to buy it off you..and eventually drop down. anyways lets just go along with your question you sold euro for the yen.. price drops.. but you wonder why price drops in EUR/USD even though that pair is untouched.. this happened because the euro dropped.

your EUR/JPY example.. when u buy the euro and sell.. you arent buying the euro and selling the yen.. you are buying the euro and selling the euro. when you go short and sell.. you are buying the yen and only selling the yen.

its my fault i didnt understand your question before. sorry
  • #11
  • Oct 13, 2011 6:53am Oct 13, 2011 6:53am
Not sure if this is what you're looking for, but different currencies dominate all of the time, and some currencies will temporarily dominate. For example, USD is the leader, so if USD is going up, all pairs against USD will go down. EUR is also very strong, so it will almost always dominate. CAD is weaker, so you'll see some pairs bullish CAD and others bearish CAD.

AUD is a weaker currency because Australia's GDP is lower than the other major pairs, but with the Western economy as it is right now, and Australia with the highest interest rate of the majors, and Australia's economy closely tied to a growing China, AUD spent the last couple of years dominating above all pairs, including USD, because of this.

Hope that's what you were looking for.
  • #12
  • Oct 13, 2011 7:15am Oct 13, 2011 7:15am
Ishii1, I think we may be in danger of going off topic with this, but I have to address some of what you said.

If I sell 1 Billion EUR against the USD, the price is much more likely to go down as I claim, rather than up as you claim. I am selling into BID's which are placed by liquidity providers, and I can only sell all 1 Billion EUR if someone else is prepared to buy from me at set prices. The BID's are at different price levels, and it is almost certain I would not be able to sell all 1 Billlion at the same price. I would sell perhaps 100 Million at the best current BID price. Once that BID is consumed then I could only sell my next 100 Million at the next lowest BID which may be 1 pip lower. I would continue to consume those BIDS all the way down different price levels until I had sold all 1 Billion EUR that I wanted to sell. By that time, the best available BID in the market for others to use, may be 10 or 20 pips lower from when I started my selling.

So if I am a heavy seller, and I outweigh the buyers in my volume, the price is going to drop on the EURUSD. It has to.

As for you saying that when I sell the EURJPY pair I am actually buying the EUR "AND" selling the EUR, what would be the point? Imagine going in to a grocer shop to buy an apple, and paying for it with an apple....what would be the point? I would be left with exactly the same thing as I had before I started the transaction, as would the poor soul on the other side of my trade. Currency pairs are a market like any other, where we exchange one item for another "different" item. If I buy EUR in the EURJPY pair, I have to be simultaneously selling the Yen. It's the currency "exchange" and I am exchanging one currency for another.

I think perhaps we are both completely misunderstanding the other's meaning which is leading to our confusion. You actually answered my initial question on your very first post, so I am very grateful to you. Amazingly I had never heard of the Trade Weighted Index. The trade weighted Index explains exactly how and why the buying or selling of a currency in one pair, will instantly impact all the other pairs. I've learned a great deal on that front, so thank you, and apologies if I've confused the matter by not stating my question clearly enough.
  • #13
  • Oct 13, 2011 7:45am Oct 13, 2011 7:45am
im glad we got that covered from the beginning.. anyways i would like to explain why when u buy the EUR from the EUR/JPY and sell u are actually selling the EUR.

you should also look up bull trap. (im going to create random figures just for the explanation). lets say you went long AUD/USD price at 1.10.. that meanings you bought in hope that the AUD will rise and theres a floor (s/r) at 1.05.. the price starts to drop.. its at 1.06 and you think that if it goes any lower.. its gonna hit your stop loss and you are out..

you place your stop loss at 1.05 at a typical s/r.. and so did a million other traders.. and big institutions can see that.. so what they do is.. inject millions and millions.. theres a case of the company west farmers injecting like 600m into the USD.. forcing the price to go down.. the price drops below 1.05 and hits your stop loss and the millions of other traders stop loss aswell.. then.. they counter trade.. they inject more money into the AUD (long)

what do you think happens? it hits your stop losses causing you and the other traders to automatically sell (remember you went long.. u bought AUD)

which forces the AUD to rise.

you see what i mean now? sorry if its unclear i typed it as fast as i can
  • #14
  • Oct 13, 2011 8:00am Oct 13, 2011 8:00am
I think I understand what you were getting at now. Yes, I agree, in a speculative trade I will first buy a currency, and later sell the same currency (or vice versa). I misinterpreted your meaning by thinking you were somehow claiming that in one single transaction I am buying and simultaneously selling the same currency: at the same exact time.

But I was talking about an individual transaction. It is very easy for us retail traders to get in to the mind set of thinking our trades are just one transaction because we always have to enter and exit a "trade" which involves first buying and then later selling the same currency (or vice versa). But in reality the open and close of our trade are two unrelated transactions which only have a relationship from our perspective. When I enter a speculative trade, that is one individual transaction which is completed instantly. I buy the EUR and simultaneously sell the JPY.....end of deal and there is no reason why I would ever have to exchange the currencies back again in the future. If at some later date I chose to exchange the currencies back and this time sell my EUR and simultaneously buy JPY, that is a completely different transaction, totally unrelated to my first, even though in my head I am "closing" one single "trade".

As is so often the case, we were both interpreting the other persons comments out of context for how they were intended. I think we've got there now
  • #15
  • Oct 13, 2011 1:50pm Oct 13, 2011 1:50pm
Quoting flotsom
I think I understand what you were getting at now. Yes, I agree, in a speculative trade I will first buy a currency, and later sell the same currency (or vice versa). I misinterpreted your meaning by thinking you were somehow claiming that in one single transaction I am buying and simultaneously selling the same currency: at the same exact time.

But I was talking about an individual transaction. It is very easy for us retail traders to get in to the mind set of thinking our trades are just one transaction because we always have to enter and exit...
Interesting point. I wonder if the distinction lies in the broadly correlative effect of speculative waves as opposed to commercial purchases (say by an exporter). In that context, index weighted adjustments would make sense.

Notwithstanding, this is a very useful discussion. It has got me asking questions as well.
The road to pipland is arduous and fraught with challenge.
  • #16
  • Oct 13, 2011 3:42pm Oct 13, 2011 3:42pm
Quoting flotsom
For example, when the EUR is weakening, it will drop simultaneously against the USD, CHF, JPY, GBP etc. On the face of it this seems perfectly obvious, but with a little more thought, I just can't understand the reason or the mechanics behind it.

Your understanding of currency valuation is flawed most likely due to reading some of the moronic things that so-called "experts" around forums such as these have posted.

They have no idea what the hell they're talking about.

In reality, it is a very simple philosophy.

If one currency weakens, a price pair will move in favor of its opposing currency. Doesn't matter what currency it is. If this does not happen, then that means both currencies in that pair are weakening at the same time.

Simple as that. There are no other factors that influence this phenomenon.

People who claim anything otherwise are ignorant idiots that probably suck at trading as well, I would guess.
  • #17
  • Oct 13, 2011 5:26pm Oct 13, 2011 5:26pm
Quoting flotsom
What I'm trying to understand is why (or more importantly how) selling/buying on one pair would impact another pair.

If I was a major player and I sold 1 Billion Euro in exchange for Yen causing a fast drop in the EURJPY price as I consume the available BID's in the market, why would the EURUSD price also immediately drop significantly when I didn't touch that pair? Does this make more sense as to my question?

There is no major selling of EUR against the USD, and yet the EURUSD pair would most certainly drop in unison with the EURJPY. This...
Hi flotsom:

By no means do I consider myself a currency trading expert; it's just a fascinating hobby for me. However, I do understand your question above and it immediately made me think of Triangular Arbitrage and High-Frequency currency trading by banks and other large institutions. Their super-computers are constantly on the lookout for any imbalances in a currency triangle (or even in more-complexly shaped arbitrages beyond a triad). Any disrepancies from a large trade throwing a single pair out of whack will quickly become rectified by high-frequency arbitrageurs.

http://en.wikipedia.org/wiki/Triangular_arbitrage

There are other factors, to be sure, but what I mentioned above has to be a significant contributor to the balancing of related currency pair movements.

Good luck being a retail trader though. It's a pool of sharks out there!
  • #18
  • Oct 13, 2011 9:56pm Oct 13, 2011 9:56pm
Quoting Timevalue
... Triangular Arbitrage ...
Wow, it amazes me how many posts it took before someone gave the correct answer
  • #19
  • Oct 14, 2011 1:10am Oct 14, 2011 1:10am
Quoting kibescorp
Your understanding of currency valuation is flawed most likely due to reading some of the moronic things that so-called "experts" around forums such as these have posted.

They have no idea what the hell they're talking about.

In reality, it is a very simple philosophy.

If one currency weakens, a price pair will move in favor of its opposing currency. Doesn't matter what currency it is. If this does not happen, then that means both currencies in that pair are weakening at the same time.

Simple as that. There are no other factors...
It's not that my understanding of currency valuation is flawed as such, more that I clearly did not pose my initial question in a manner which correctly reflected what I wanted to know. My fault entirely for confusing the issue.

My question is nothing to do with the relationship between currencies in a single pair. I completely agree with you that if a currency weakens, the "pair" will move in favour of the opposing currency in that "pair". My question isn't really even about the relationship between multiple currencies in the broader sense.

My question was about the mechanics of why/how "other" pairs would also move even though the buying or selling was taking place in a different pair. If there is heavy selling in the EURJPY pair, why would the EURUSD, EURCHF, even the USDCHF also move without any direct heavy selling in those pairs? And the answer was given to me in the very first reply about the trade weighted index.

I realise on forums there are a lot of axioms thrown about such as "it's all to do with supply and demand" etc, but very few people ever talk about what that means or how it is translated in to the prices we see on a quote board in real time. It's a bit like a car. Most people know they work based on a combustion engine. If someone asked the question, how does a car work, they would be bombarded with answers that it's all about the engine. But very few people would actually be able to tell you precisely "how" the engine works from the point of pressing the start button all the way down to the wheels turning.

That was really the gist of my question; I wanted to know "how" the engine worked. I wanted to know why price changes would instantly appear in the USDCHF even though the heavy activity was taking place in the EURJPY which on the face of it is unrelated. Prices can move without any buying or selling taking place. This is obvious to anyone with just a small amount of knowledge and experience, and it was obvious to me, but I wanted to know exactly why and how. I feel I now have the answer with the trade weighted index, and with more research and study I will hopefully soon have a much better understanding and knowledge.

As I said in my opening post, the question was deeper than most people would give it credit for, but I obviously didn't word it in a way that could be easily interpreted by others. That is entirely my fault for not translating my thoughts properly.
  • #20
  • Oct 14, 2011 1:21am Oct 14, 2011 1:21am
Quoting Timevalue
I do understand your question above and it immediately made me think of Triangular Arbitrage and High-Frequency currency trading by banks and other large institutions.
Thanks for the input. That will certainly give me something else to consider in the equation. I've heard a lot about triangular arbitrage but never really paid any attention to it. I can immediately see that combined with the understanding of the workings of the trade weighted index, this kind of high frequency trading of arbitrage situations could significantly effect prices on other pairs.

As time passes I am amazed at how little I really know and understand. I don't know whether to be worried or amused that I have been able to trade for a living for 3 years, even though I don't really know how the market I trade works. That's either indicative of the reasoning that "simple" works best for traders, or........I've had a fantastic streak of good luck which could come crashing to a spectacular end. For the sake of my sanity I think I'll go with the former.
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