Understanding the power of correlation in trading and investing

Today I would like to share some information on the Correlation ofdifferent Financial Instruments. Understanding the correct correlation is useful for traders and investors to make good trades and to manage the overall risks.

For Instance Eur/Usd and Gbp/Usd have very positive correlation (more than +91%) and at same time Eur/Usd and Usd/Jpy have strong negative correlation ( more then -72%). If a trader is taking big positions in any of the above pairs, then having a correct knowledge of correlation will be very useful for proper risk management of overall portfolio.

Understanding the correlation of Gold with AUD/USD and with USD/CHF

As we know that the U.S. dollar and gold don’t quite match very well. Usually, when the dollar moves up, the gold mostly falls and vice-versa.

The main logic here is that during times of economic unrest, investors tend to dump the USD in favour of gold because gold consider as safe heaven.

Gold’s positive correlation with AUD/USD

Currently, Australia is the third largest gold producer in the world, sailing out more than about $5 billion worth of the Gold every year! The gold price and AUD/USD have a strong correlation historically. This stable relationship remains as Australia is the world’s second-largest gold producing country after China, and the reason why the Aussie is known as a “commodity currency”

Gold has a positive correlation with AUD/USD.

When gold goes up, AUD/USD goes up. When gold goes down, AUD/USD goes down.

Historically, AUD/USD has had more than 82% correlation to the price of gold!

The Gold and AUD trading strategy

With a tight correlation between gold and the Aussie, there is a opportunity of a Pair Trading Strategy.  Pair Trading refers to simultaneously buying an asset and selling a related asset at the same time. A strategy to reduce some of a trader’s directional risk is Pair Trading. Pair trading extends time duration and reduces trade risk but doesn’t necessarily mean higher probability profit. If the relationship in the pair breaks down, then there may be trading opportunities. If the correlation breaks because the gold price rallies and the Aussie doesn’t follow along, Pair Trading Strategy offers trading opportunities.  This divergence can be exploited by shorting gold (the strongest instrument) and while simultaneously going long on the AUD/USD. Once the value of both the gold and Aussie revert to the statistical mean, a profit will be made.

The advantage of going long on AUD/USD than buying directly Gold

In a long-term basis, the Aussie follows similar price patterns to the gold price. Many traders and investors even prefer to go long on AUDUSD than buy directly gold contracts and there is a good reason for that. Gold is not offering any interest rate. Moreover, if you go long on a Gold contract you will be forced to pay an overnight rate (negative swap value). On the other hand, the Aussie against the US Dollar offers positive swap value, and that means it pays you an overnight rate. For long tern trade this may be advantage.

Other Australian Dollar correlations

During the past two decades, the correlation between copper and AUD is more than 72%.

The Aussie is also correlated to Silver and other Commodities.

The Aussie is also highly correlated to the New Zeeland Dollar (more than 91%).

Gold’s positive correlation with CHF

Switzerland‘s currency, the Swiss franc, also has a strong link with gold.

The reason why the Swiss franc (CHF) moves along with gold is because more than 25% of Switzerland’s money is backed by gold reserves.

When gold goes up, CHF goes up. When gold goes down, CHF goes down.

I strongly believe that with good knowledge on correlations of different instruments one can have more good edge on risk management. Forex is a huge market and it’s always good to learn and know new stuff continuously.

Trading is all about emotions and better risk management. Once you understand this concept then will be easy for you to trade like a professional trader.