Correlation is a statistical measure of a degree to which two assets are linked and move in relation to one another. The correlation coefficient is the number which shows the strength of the relationship between the movements of two assets. It ranges between -1 and 1. Two assets are strongly negatively correlated if in 100% of times one rises in value while the other at the same time falls. If the two assets in 100% of times move in the same direction, they have a strong positive correlation. No correlation is the situation in which the two assets moves arbitrarily in relation to one another.
In trading, correlation is important for several reasons. Understanding the correlation between currency pairs prevent overtrading and harmful exposure to the same assets. It could be used to create a portfolio with desired volatility and maximized return/risk ratio. It is the process known as portfolio optimization. Assets with low or negative correlation could be in the same portfolio and the risk will be diversified.
In Forex many currency pairs are intertwined. Apart from currency correlations, there is a correlation between currencies and indexes and between currencies and commodities. EURUSD and GBPUSD have a strong positive correlation. USDCHF and EURUSD have a strong negative correlation. Canadian Dollar (CAD) and oil are strongly positively correlated as the oil is the main export commodity for the country. Another example is the correlation of the Australian Dollar (AUD) with gold, as the country is one of the leading gold producers in the world.
However, it is important to keep in mind that the correlation can also change or break due to political or economic reasons. Investors’ sentiment and global factors are very dynamic thus strategies based on short-term correlations could not be applicable in the longer term.