Currency Correlation And How to Profit From The Forex Market

What is Currency Correlation?

1. Positive correlation is when two or more pairs trade in the same direction at the same time. For example when EUR/USD is trading up GBP/USD is also trading up.

2. Negative correlation is when two or more pairs trade in opposite directions at the same time. For example when EUR/USD is trading up the US Dollar Index is trading down.


How Can Currency Correlation Help Us Trade Profitably?

Since we know a pair is positively/negatively correlated with another we can look for hints the market leaves behind before a move happens. Woah no way???

What are these hints?

If a pair is positively correlated with another both should be making higher highs or lower lows at the same time. For example view the 4H chart below comparing EUR/USD and GBP/USD

http://i1083.photobucket.com/albums/...ps249fd2f8.png

Each higher high or lower low is happening at the same time stamp!

Knowing this one must ask him/her self what happens when one currency pair fails to follow the above pattern. For example lets say GBP/USD makes a higher high while EUR/USD makes a lower high. This is defined as a crack in correlation or falling out of correlation. Whichever you prefer. Please view the chart below demonstrating how this looks.

http://i1083.photobucket.com/albums/...ps4195dbd1.png

This is exactly the type of situation we are looking for. When two positively correlated pairs fall out of correlation at a major support or resistance level we can expect a reversal. This reversal may be as small as 25 pips but more often than not it results in larger moves. For example today's price action below.

http://i1083.photobucket.com/albums/...pse6c87c22.png

Don't expect 250 pips every time! As stated above the resulting moves can be as small as 25 pips but more often then not 50-100 can be expected. Again I must reiterate this method is to be used in conjunction with major support and resistance levels such as Big Figures and Mid Fgirues for example 1.3500, 1.3550, or in this case 1.3000. Of course it doesn't have to happen at a mid/big figure the only requirement is that it does happen at a major support level such as a daily or 4H.

Negative Correlation

Negative correlation is when two related price units trade in opposite directions at the same time. When EUR/USD makes higher highs the US Dollar Index forms lower lows. Example below

http://i1083.photobucket.com/albums/...ps2c5966c9.png

We can look for a crack in correlation such as E/U making higher highs while USDX fails to from lower lows. Example below


http://i1083.photobucket.com/albums/...ps994388c5.png



Examples with the help of NetDania Charts since Oanda mt4 doesn't offer USD Index.

If you'd like to try NetDania charts follow the steps below.

1. Open NetDania Charts
2. Right click chart > New > Choose instrument
3. Right click chart > Overlay > Second instrument


How the heck do we trade this???

Note: Long term signals are more reliable than short term. 1m is useless. 5m will has more losses than 15m. This isn't to say not to trade the 5m chart though it can be profitable if you trail stops to break even +10 quickly. Most 5m signals are good for 10-20 pips and sometimes it's possible to catch the daily high/low reversal for 60 to 100+. 4H and Daily will provide the most pips but these trades can take weeks/months to reach profit targets. Best case scenario would be to find a 1D+ divergence and 1h divergence forming at the same time @ a major s/r level like 1.3000. This doesn't happen vary often but when it does price explodes.

Click here for step by step trade example

Here are a few options.

Important - Always wait till the diverging bar has closed. For example if a 15M divergence appears on the current candle do not trade till the current candle has closed.

1. Wait for a bar to close in the direction of the divergence signal. Example. E/U makes a higher high G/U doesn't the next few bars happen to be doji's or small greens and finally a bar closes to the sell side. Enter at the close of this bar as long as the divergence is still valid.

2. Trade your favorite system. Look for a signal in the opposite direction of the current trend. <- Scalping systems might get a signal for 15M divergence entry?

3. Wait for a retest of the divergence candle high/low.

4. Set a limit order and wait for the breakout to occur <- Maybe the best option for newbies?

5. Combine 1, 3, and 4 - If when price reverses the risk is vary small enter. If the risk is a little to much for your liking at the next up/down bar wait for a retest of the diverging swing high/low. If price fails to retest set a limit order to breakout trade.


Stoploss

Stops should be set to the most recent swing high/low or x number of pips above/below the swing. In the example below a stop loss would be placed at or above the divergence swing or the most recent swing high depending on when you got into the trade.

Take Protfit

Profit points can be figured a number of ways. I like Fibonacci extensions (swing projection) 1.272, 1.618, 2.0 and 2.618. In extreme cases 4.236 extension will be my last target where all remaining profit is taken. Also note how price acted within these Fibonacci extensions yesterday price ranged between 1.272 and 1.618, stalled around 200% and traded within 6 pips of 2.618 before the market closed for the weekend.


http://i1083.photobucket.com/albums/...psbf0664f3.png





Please note - I (and many others) were taught how to trade this method by mentor Michael Huddleston. My only goal here is to teach you a vary simple and profitable method of trading. If for whatever reason you decide this can't possibly be true please go elsewhere and trade another method.




The indicator attached below will automatically plot Mid and Big Figure levels. For example 1.3000, 1.3500, 1.3550 ect. Fun experiment - Load this indicator on a 1H or 15M chart and note how price reacts at these levels.

What else ..?
I'm wanna know more

To understand currency correlations, you need to think in terms of individual currencies rather than pairs of currencies.
When something happens to drive up the value of a particular currency, it strengthens against all other currencies.
When something happens to drive down the value of a particular currency, it weakens against all other currencies.
In the examples above when GBP/USD falls faster than EUR/USD, it means EUR/GBP is strengthening (either EUR getting stronger or GBP getting weaker)

Yes, but the vast majority of those pips are due to announcements first by the BOE and then the ECB and have nothing to do with correlation failures.

Good article

I use pair correlation to avoid trading twice the "same" move. Pretty useful when you think about it. Imagine risking 1%/trade on 3 pairs that are highly correlated. You think you're being reasonable, but actually you're risking 3% on essentially the same trade.

"The result was a 250 pip drop"
"As you can see we made a few pips"

So what are you saying ?
If one fails to make a higher high when the other does, go short?
The drop was because the USD strengthened and no other reason.

Hold on to your britches I'll release more information today

I can give you a bunch of examples of this happening before major news releases. How do you explain that? Set your charts up for 15M, 1H or 4H, scroll back in time, and look for a divergences between E/U and G/U then note the resulting moves in the opposite direction. The key here is we are not looking for just divergence between correlated pairs we use this in combination with support/resistance levels or implied S/R such as mid figures and big figures for example 1.3500, 1.3550, or in this case 1.3000.

Also note this trade is in the direction of the current trend which makes for smart trading. Anyone wanting to test this strategy try only trading with the trend till you get a grasp of what major support and resistance levels are. On a basis of normal support and resistance trading alone we can expect some sort of reaction at round numbers and 50 pip levels. Correlation divergence only further increases the probability of said reaction happening.

My mentor taught this method to hundreds maybe thousands of people giving complex and specific reasons why these "cracks" in correlation happen. It all has to do with how price moves (market flow) and how market flow and correlation work together. The theory here is when market flow and correlation do not match we have a crack in correlation. This then suggest the market has exhausted it's current trend or retracement and is about to reverse for some period of time. Other than that vary simplistic description I can't explain why it happens but I can in fact show you that it does indeed happen and that it happens before big moves such as a large impact news announcement in the correct direction of said news announcement.

Disagree all you want I've been studding this method of trading for 5 years dedicating my trading career to mastering this one philosophy. It truly is a reoccurring phenomena of the market.

You got my attention, would definitely like to hear more.

I can see that E/U and G/U move away and back together, but how do you know which one will move to correct?

Martin

Exactly the reason I trade only one pair at a time (either e/u or g/u not both)

Good question I totally forgot to add that to OP. A couple of ways you can figure which will move more pips

1. Generally speaking G/U will trade more pips on a give price swing when compared to E/U.

2. The currency which makes a higher high or lower low is likely to move the furthest since price needs to get back in sinc with market flow and correlation. For example if E/U makes a higher low and G/U makes a lower low then the resulting reversal happens. Throughout this reversal E/U takes out a former higher high G/U now needs to trade more pips to take out it's corresponding high since it started much lower relative to e/u's starting position.

Make sense?

In Theory, yes I understand

However puttting it into practice might be another matter. Could you show some charts for example trades?

The reason EUR/USD and GBP/USD are correlated is because the economic fortunes of Europe and Britain are intertwined with each other. Try superimposing one on the other, then comparing it to EUR/GBP.

I didn't say you are wrong - I actually like your approach, it is similar to what I do. But you are limiting your view to currency pairs and only looking at past data, making a lagging indicator. I have dozens of correlation charts like the ones you have posted here but I also include charts of leading fundamental indicators - risk barometers such as gold and equity indices, interest rate cycles, bond yields and spreads, sentiment/positioning, current accounts etc. Each currency puts a different weight on different economic factors. Try finding correlations and divergences between all those things, and instead of studying past data you will be predicting future moves.

You could also say the reason EUR/USD and GBP/USD are correlated is because they both have the common denominator of USD. Which is my reasoning for using the 3 charts described throughout this thread EUR/USD, GBP/USD, and USD Index. Sure it can be complicated even more by adding in COT data, 5, 10, 30 year T Bonds, top 3 us stocks Dow Jones, NASDAQ, SNP 500 and more. All of these market are in one way or another connected to how the USD Index trades and by extension EUR/USD GBP/USD. One could also add AUD/USD, CAD/USD, NZD/USD. All of these pairs are positively correlated however the 2 that move the most pips consistently day after day are E/U and G/U. Which is why I've chosen to simplify and focus on these 3 instruments.

This is supposed to be a simple and easy approach to trading. Maybe later on if this thread attracts more followers I'll add to it. However for now let's keep it simple and easy. If a newbie stumbled upon this thread and we were checking 10 different charts to make a decision to trade or not to trade most would skip over the tread because it's to complicated. This again is simple and easy more importantly though it doesn't involve indicators price is the indicator.

Sure thing

Here's a step by step view of how a live trade would look in real time. Please note in the example below trading the vary first up bar would have been the most profitable decision with the least risk. This is not always the case because sometimes the breakout swing can be quite a few pips from the next up/down bar. However breakout trades can be profitable to as shown below.

Entry's and Exits are a per trader judgement call. I'd rather risk less by entering early or on a retest rather than trade the breakout. This way instead of risking 30ish pips I'd have risked 10-15. This not only halves the risk it improves profit. If risking 2% on a 30 pip stop each pip is worth half as much as risking 2% on s 15 pip stop.


Step 1: EUR/USD made a lower low while GBP/USD has failed to do so.

http://i1083.photobucket.com/albums/...ps0de1d70c.png

Step 2: Wait for a retest of the divergence swing. No retest occurs so we set a limit order for a breakout trade.

http://i1083.photobucket.com/albums/...ps32ccd946.png

Step 3: Entry is triggered. If you haven't done so place a stop loss at the most recent swing low.

http://i1083.photobucket.com/albums/...psb0c6f1d7.png

Step 4: Draw a fib on the diverging swing for profit levels. Don't forget to trail your stop to break even. In this case the risk was 35 pips so trail to break even at 25-30 pips. As you can see in this case all fib extensions were hit for a profit of 108 pips. Lets say Bobby didn't want to hold a position over night so he got out when price started to consolidate after the strong up move. Bobby would have made +75 pips. Not to shabby Bobby

http://i1083.photobucket.com/albums/...pse9f5f618.png

Interestingly enough if you look to the right side of the chart another divergence occurred the vary next day to the sell side.

OK. I trade higher TFs and only take 1 -2 trades per week, so I spend 20 - 30 hours analyzing and planning each and every trade. I can see how my approach is irrelevant here.

When you are comparing EUR/USD to GBP/USD though I think using the USD index is kind of redundant since both pairs are equally grounded in USD. I also hope you realize that when looking at the differences between EUR/USD and GBP/USD, what you are looking at is the relationship between EUR and GBP. Also known as EUR/GBP. You can prove this with a calculator by multiplying the current price of G/U by the current price of E/G - the result will always be the current price of E/U (give or take the spreads).

I wont argue about this any further. The fact that both pairs are "grounded" to USDX is exactly the point. Trade however you want to trade and I'll continue doing what I've been doing for 5 years.

Do you wake up in the morning and decide today I'm going to try disproving someones forex system? You've been added to my ignore list don't expect another reply.

Thanks for the method Jonny, I have never looked at diveregence this way before. do u have a skype name/group, where we coud trade this method together?

Kind Regards

Abie

Hi Johnny do you still use this method? How about we open a discussion group on telegram with other traders.