Hedging and Correlation – Chapter 12 | Learn Forex

Currency correlation:

Correlation indicates the relation between two mutually dependent variables at a certain time. In the forex world, it means how two currency pairs statistically move either in the same direction or in the opposite. Therefore correlation values can be either in positive or in negative between 0 to 1.

Correlation value can be calculated for any two securities, not necessarily only between currency pairs. Example, AUDUSD vs Gold

Use of currency correlation in trading:

Correlation values are widely used in different kinds of trading, including hedging (explained later).

Hedging:

Hedging means having a buy and sell trade all together on the same securities or multiple securities that are correlated with each other and aggregating the total position value for profits or reducing the loss.

Hedging can be done by opening trade on the same currency pairs at the same price or different prices also in combination with other correlated currency pairs. Sometimes, hedging is used to fix the amount of loss (ignoring the swap charges)

Practical example:

Suppose a trader opened a buy and sell order at 1.2510. That means no matter what direction market moves, both buy and sell orders are hedged. The trader will see the commission or spread cost and swap fees. (One swap fee will be positive and one will be negative)

For loss reduction:

Suppose a trader has an open position at 1.2550 buy order is currently at 20 pips loss as the market has fallen to 1.2530. So If he has not set any stop-loss he could just open a sell order at 1.2530. It will hedge the position with 20 pips maximum loss.

Basket trading:

One of the popular trading strategies among traders where they open multiple orders in different correlated currency pairs for hedging the overall position.

In this way, the overall position will be less risky and will generate a stable profit.

The term basket is used here because orders are placed with one single base currency and its combination with other currencies. Below is an example with GBP basket:

Total: $3.23 profit