In this article, We learn about "Correlation ".Let's Go!
In trading, “Correlation” is a statistical measure that describes the degree to which two securities are related to each other.
Correlation is used for advanced portfolio management and is calculated using the correlation coefficient, which ranges from -1 to +1.
The meanings of these values are as follows:
Positive correlation (value close to +1):
This indicates that both securities are moving in the same direction at the same time. If one security goes up, so does the other; if one falls, so does the other.
For example, EUR/USD and GBP/USD typically move in the same direction because both pairs are correlated to the US dollar. When the US dollar weakens, both EUR/USD and GBP/USD typically rise; when the US dollar strengthens, these currency pairs typically fall.
Another example might be two stocks in the same industry, they might both benefit from the same economic factors.
Negative correlation (value close to -1):
This indicates that the two securities are moving in opposite directions. If the price of one security rises, the price of another tends to fall, and vice versa.
For example, EUR/USD and USD/CHF typically show a negative correlation. When the greenback is weak, EUR/USD may rise while USD/CHF may fall.
Another example might be certain stocks and bonds, since they are usually inverses of each other. When stocks do well, bond prices can fall as investors move into higher rewarding (and riskier) stocks, and vice versa when stocks do poorly.
No correlation or zero correlation (value close to 0):
This shows that there is no detectable pattern between the price movements of the two securities.
Why is relevance important?
Correlation is an important concept in diversification, the strategy of combining various investments in a portfolio to reduce risk.
The idea is that if the investments are not perfectly positively correlated, some investments will go up while others will go down, thus balancing the performance of the portfolio.
Understanding FX correlations can help manage exposure and risk.
For example, if you have positive exposure to EUR/USD, you might choose to offset some of your risk by taking a negatively correlated position in USD/CHF.
However, it is important to remember that correlations may change over time due to changes in
market conditions, geopolitical events, or economic factors.
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