What Is Correlation?
Correlation measures the statistical relationship between two assets’ price movements. It ranges from +1 (move together perfectly) to -1 (move opposite perfectly) to 0 (independent).
In trading, correlation matters because it affects your portfolio risk. Two trades on correlated assets magnify your exposure; two trades on uncorrelated assets diversify it.
The Correlation Scale
+1.0 — Perfect positive correlation
- Both assets move in same direction, same magnitude
- Example: 1-year and 2-year Treasury yields
- Trading implication: Redundant exposure
+0.80 to +1.0 — Strong positive correlation
- Assets move together most of the time
- Example: EUR/USD and GBP/USD (0.85-0.95 typically)
- Trading implication: Similar risk exposure
+0.50 to +0.80 — Moderate positive correlation
- Assets usually move together but with divergences
- Example: Stock and bond indices during normal times
- Trading implication: Some diversification benefit
0 to +0.50 — Weak positive correlation
- Assets have weak relationship
- Example: Tech stocks and precious metals
- Trading implication: Good diversification
-0.50 to 0 — Weak negative correlation
- Assets slightly move opposite
- Example: Stocks and government bonds in normal times
- Trading implication: Some hedging benefit
-0.80 to -1.0 — Strong negative correlation
- Assets move in opposite directions
- Example: Gold and USD (often move opposite)
- Trading implication: Effective hedge
Common Forex Correlations
Positive correlations (move together):
- EUR/USD & GBP/USD: 0.90 (strong)
- EUR/USD & AUD/USD: 0.85 (strong)
- AUD/USD & NZD/USD: 0.90 (strong)
- USD/JPY & USD/CHF: 0.80 (moderate-strong; both safe havens)
Negative correlations (move opposite):
- EUR/USD & USD/JPY: -0.70 (moderate-strong)
- GBP/USD & USD/JPY: -0.65 (moderate)
- Gold & USD/JPY: -0.40 (weak)
Why Correlation Matters in Trading
Diversification:
- If you’re long EUR/USD and GBP/USD, you don’t have diversification (correlation = 0.90)
- You essentially made the same bet twice
- One pair falling means both fall
Risk calculation:
- Two independent 2% losses = portfolio loss of ~2.8%
- Two perfectly correlated 2% losses = portfolio loss of 4%
- Uncorrelated assets reduce portfolio volatility
Pairs trading:
- When correlation breaks (EUR/USD strong, GBP/USD weak), you exploit the divergence
- Bet that correlation returns to normal
- High probability if historical correlation is strong
Measuring Correlation
In Excel:
=CORREL(range1, range2)
Requires price data for both assets over the same timeframe.
Timeframe matters:
- 1-month correlation: 0.75
- 3-month correlation: 0.88
- 6-month correlation: 0.91
- 1-year correlation: 0.90
Longer timeframes reveal stronger relationships.
Correlation Breakdown (Crisis Periods)
During extreme market stress, normal correlations break:
Normal times:
- Stocks & bonds: -0.10 (slightly negative)
- Gold & stocks: -0.20 (weak negative)
Crisis (2008, 2020):
- Stocks & bonds: -0.80 (strong negative, bonds rally while stocks crash)
- Gold & stocks: -0.60 (stronger negative)
Your diversification disappears when you need it most.
Using Correlation in Your Journal
Track:
- Which pairs did you trade together?
- What was their actual correlation?
- Did they move as expected?
- When did correlations break?
- Did those breaks create opportunities?
Over time, you’ll know which pairs truly diversify and which just magnify exposure.
Implications for Position Sizing
If you trade EUR/USD and GBP/USD (correlation 0.90):
- You’re essentially doubling exposure to the same risk
- Combine them: treat as a single position, size accordingly
- Reduce one position size if you hold both
If you trade EUR/USD and USD/JPY (correlation -0.70):
- They offset each other
- Lower total portfolio risk
- Can size each position normally
The Takeaway
Correlation is the hidden risk in your portfolio. Two trades that “feel” diversified might actually be highly correlated, magnifying your risk in the direction they both move.
Calculate correlation before entering a second position. If correlation is above 0.70, you’re adding redundant exposure. Below 0.50, you’re diversifying. Use this knowledge to size positions appropriately and protect your account.
Correlation changes over time. Monitor it. When correlations break, opportunities emerge for observant traders.
