Correlation VS Diversification

Many traders believe that trading different pairs is diversification. This can be very wrong. Many currency pairs are correlated. For example, if a trader goes long EUR/USD and long GBP/USD to diversify their trading. He will find himself increasing his risk instead of diversifying his portfolio. Trading EUR/USD and GBP/USD for the same direction will double your exposure to the USD. Another example would be going long on EUR/USD and going short on USD/JPY. Let’s make this example clearer;

We are going long EUR/USD and short USD/JPY so the formula would be like this:

==> The result would be buying 1 lot of EUR, 1 lot of JPY and SELLING 2 lots of USD.

I will take the above example and invert it. In this new example, I will be buying EUR/USD but I want to partially hedge my position to stay on the safe side. In this case, I will buy EUR/USD and buy USD/JPY;

In the end, we have hedged our exposure to USD. This means that we won’t be affected at all by anything the USD may do. Instead, we are buying EUR against JPY. If we are about to take these 2 positions at the same time, it would be a lot better to just buy the EUR/JPY pair. This will avoid us to pay a double spread (one for EUR/USD and another one for USD/JPY) Instead we will be paying the broker just the EUR/JPY spread.

Now, why am I mentioning all this? Most of us here, come to FXSTAT to check for the best performance and invest with its owner. Now it is imperative that we check the safety of the systems. We need to check the history statement and When you are choosing to invest in any performance here at FXSTAT. We need to check the statement’s history and see if the owner is respecting this concept.

For example; I am watching a performer that has amazing results. The system seems to diversify the portfolio with different trades. I check the trading statement and see that at some point the system went long simultaneously on EUR/USD, GBP/USD, AUD/USD.

So, what is he doing? He is shorting USD for 3 times the size of a normal position!! That’s 3 times the risk for this set of trades. But, that’s not all! He is also going long for EUR, GBP and AUD. These 3 currencies are correlated to each other. This means that instead of diversifying my portfolio to avoid serious drawdown, the performer is taking 3 times the usual risk!

Thanks for this explanation. I was never aware of this concept. I have a questions though, how you can determine that euro, gbp and aud are correlated? Is it something you have to remember?

I am having trouble upload pictures on the forum but you can google forex correlation tables You can check this table if you want. But do not take it religiously as correlation change with time. Also, you don't really need to memorize it for sure! Just get the feel of it. Mainly, any pair that ends with the same currency like eur/usd, gbp/usd etc... are correlated and pairs that start with the same currency like eur/usd eur/jpy are correlated...

thanks I have made some research on that and I think I got it. The only thing I do not understand is why correlation varies? It would be great if you expand on this a little...

Currencies have their own moves. Even if euro and pound for example are correlated. Each of them has its own economics. If euro and pound where 100% correlated, we wouldn't have the pair eur/gbp.... Some short or long term events will create some trouble with the correlation. for example, yesterday's events have affected the euro but not the pound. As a result the euro went up but the pound kept ranging. check this: http://www.fxstat.com/forum/showpost/25-Trading-Discussion/130-EUR/2#qitem276

I hope i was clear on that, let me know if you have any other questions

The graph below shows how stocks and the dollar have traded through the month of January. The red line is the stock market as measured by the mini S&P 500 futures. The black line is the cash Dollar Index. So what’s the conclusion? At times the markets definitely show a strong negative correlation. The period between January 10th and January 18thshow two markets almost totally going in opposite directions. The two markets were positively correlated during the earlier part of the month, however, and since the 18th things have been rather muddled. The point is correlations change, even from day to day at times.

And change is the key. The chart below goes back a year and plots the 1-month trailing correlation between the S&P 500 index and the EUR/USD rate (the latter being the major element to the Dollar Index). When EUR/USD is rising it means a weaker dollar, so a strong positive correlation means stocks and the buck are moving in opposite directions. Notice how much variability there’s been in the correlation just in the last year. Certainly, most of the time stocks and the dollar have moved in opposite directions (positive correlation on the above chart), including of late. That wasn’t always a strong correlation, though, and at several points the correlation was negative, indicating stocks and the dollar moving in the same direction.

Then there’s the relationship between gold and the dollar, which hasn’t been nearly as consistent as the one between stocks and the dollar. The chart below shows the last year worth of trailing 1-month correlations between the metal and the greenback. Again, here we have EUR/USD as a kind of reverse proxy for the Dollar Index. If gold and the dollar consistently trade in opposite directions we would expect to see a consistent strong positive correlation between gold and EUR/USD. That clearly has not been the case, however. Most of the time, in fact, the relationship has been the other way around – gold and the dollar generally moving in the same direction.

The changes in correlations between markets reflect changes in the primary moving force underlying those markets. Stocks and the dollar have moved in opposing directions thanks to risk on/off psychology in the past. That’s less the case now, which is why the arguments are being made about the negative correlation breaking down. There are other things, however, which can cause that inverse relationship to continue. One of those is relatively low interest rates in the US pressuring the greenback, but at the same time benefiting stocks.

Likewise, gold and the dollar have traded in the same direction at times of risk-on/off because investor money flows into dollar and into gold when there’s a lot of fear in the market. The two markets trade in opposite directions when the market is more fixated on the negative impact of something like quantitative easing on the dollar (higher money supply reduces the value of the dollar in terms of real assets).

The point is, just because one set of causes for markets being correlated or uncorrelated are no longer the major driving force, it doesn’t mean that there isn’t another set of causes that can maintain the same or similar linkage.

I share a chart of correlation plz see that also .(on the forum with the same name)

that is very simple chart with more explanation.

Originally posted by paradise

Correlation VS Diversification

Many traders believe that trading different pairs is diversification. This can be very wrong. Many currency pairs are correlated. For example, if a trader goes long EUR/USD and long GBP/USD to diversify their trading. He will find himself increasing his risk instead of diversifying his portfolio. Trading EUR/USD and GBP/USD for the same direction will double your exposure to the USD. Another example would be going long on EUR/USD and going short on USD/JPY. Let’s make this example clearer;

We are going long EUR/USD and short USD/JPY so the formula would be like this:

==> The result would be buying 1 lot of EUR, 1 lot of JPY and SELLING 2 lots of USD.

I will take the above example and invert it. In this new example, I will be buying EUR/USD but I want to partially hedge my position to stay on the safe side. In this case, I will buy EUR/USD and buy USD/JPY;

In the end, we have hedged our exposure to USD. This means that we won’t be affected at all by anything the USD may do. Instead, we are buying EUR against JPY. If we are about to take these 2 positions at the same time, it would be a lot better to just buy the EUR/JPY pair. This will avoid us to pay a double spread (one for EUR/USD and another one for USD/JPY) Instead we will be paying the broker just the EUR/JPY spread.

Now, why am I mentioning all this? Most of us here, come to FXSTAT to check for the best performance and invest with its owner. Now it is imperative that we check the safety of the systems. We need to check the history statement and When you are choosing to invest in any performance here at FXSTAT. We need to check the statement’s history and see if the owner is respecting this concept.

For example; I am watching a performer that has amazing results. The system seems to diversify the portfolio with different trades. I check the trading statement and see that at some point the system went long simultaneously on EUR/USD, GBP/USD, AUD/USD.

So, what is he doing? He is shorting USD for 3 times the size of a normal position!! That’s 3 times the risk for this set of trades. But, that’s not all! He is also going long for EUR, GBP and AUD. These 3 currencies are correlated to each other. This means that instead of diversifying my portfolio to avoid serious drawdown, the performer is taking 3 times the usual risk!

That is a great concept. Very useful. Valuable increase in my knowledge :)

Thankyou Paradise

Thanks for this post paradise! This has just been my observation in the past but has been strengthened by your concept. Another reason why I noticed this is that when brokers or signal providers provide notifications and signals about Eur/Usd, they also mention and relate the signals with Eur/JPY..

Thats a good explaination. Correlation and then the way of explaining diversification was nice. We now have one more way to analyze statements of the traders here.

Increasing risk by more correlated pairs means increase in return. Diversification is a good strategy if we want to minimize our risk but we will also be minimizing our profit.