Managing Exposure with Correlated Trades
Another tricky component to risk management is the ability to control exposure with correlated trades. It’s not uncommon to see similar technical setups among pairs with the same base or counter currency, so there may be instances when you’d wind up taking correlated trades.
For instance, you spot a rising channel on AUD/USD and you decide to set a buy order at the bottom of the channel. At the same time, you also saw an ascending trend line and bullish divergence on AUD/JPY so you also decide to take that trade. Meanwhile, EUR/AUD has shown a head and shoulders pattern and a possible neckline break, so you also set a short order below the support area.
When these three trades are all opened, then you will have three correlated trades that could either triple your win potential if the Australian dollar keeps rallying or triple your losses if AUD suddenly sells off.
In addition, you should also take note of currencies that share correlations with other majors. For instance, the euro and the Swiss franc tend to move in tandem, so a long EUR/USD and a short USD/CHF trade are often seen to be correlated as well.
We are going back to the market experience
It’s not that traders are discouraged to take correlated trades, but it is imperative to be aware of how such currencies can move in the same direction. If you’d like to be cautious, then you can divide your risk for the number of correlated trades you are taken or simply scale down your position sizes if you think the pairs you are trading have close to the same probability of winning or losing.
Forex websites may contain correlation tables for major and exotic currency pairs, which can help one determine if any risk management adjustments must be made. Another option could be to hedge these multiple correlated positions with an opposite trade so that the losses can be minimized if the trades all don’t go in your favor.
Something else to take note of when weighing currency correlations is the volatility of the pair you are trading. Bear in mind that some might move in your direction faster than other pairs, and when the move appears to be exhausted for some pairs, you could also think about reducing your exposure for the remaining trades that are still open.
At the end of the day though, these currency correlations are not set in stone. For instance, EUR/USD might be in for strong moves while EUR/JPY is in consolidation. In this case, one might conclude that the move was spurred by dollar action rather than euro movement.
These changes in correlations can be explained by shifting interest rate expectations or monetary policy biases, but it is always important to keep these at the back of your mind when you are taking trades with the same currency.