When you survey several forex charts you may begin to notice there are times when two or more charts exhibit similar price action. We can measure how often price action between two charts is “similar” by using a mathematical form of measurement known as correlation.

In essence this mathematical calculation computes the sum of the covariances of each price set from their mean, and then divides it by the multiplication of the standard deviations of each data set. It looks something like this ( source ):

$$ \rho_{X,Y} = \frac{cov(X,Y)}{\sigma_{X}\sigma_{Y}} $$

As a result of this calculation the correlation result will result in values ranging from -1 to 1 (or -100% to 100%). With -1 meaning the relationship between two data sets is of a strong negative correlation (when one moves up the other moves down), whereas 1 denotes a strong positive correlation (when one moves up the other moves up).

Unique Correlation Strategy With Forex Trading

One unique strategy you could look to test and analyse with your forex trading strategy is whether opening a trade in a highly correlated pair to your original trade can help minimise risk.

Picture the following scenario:

  1. EURUSD & USDCHF have a high negative correlation.
  2. Your system decides to open a LONG position in the EURUSD.

Knowing the current high negative correlation should you look to also go LONG the USDCHF?

Here are some ways you could test this strategy with your forex trading model:

Place Entry Stop Order

By placing an entry stop order going LONG at a near enough distance away from the current market price of USDCHF you allow your initial trade to have some wiggle room.

The reason why you wouldn’t want to immediately enter a highly correlated position straight away is to minimise cases where your system hit the right entry price and never retraced against you.

Therefore, by placing an order slightly away from the current market price you allow your initial EURUSD position to move against you slightly.

Wait Upon Placing Stop Order

By waiting a predetermined amount of time before placing your inverse highly correlated trade on (eg. LONG USDCHF) you remove factors where the market is extremely volatile and whipsawing about.

This minimises the risk that both positions will end up losing during the wild ride of the volatile market your system has entered both trades in.

Remove Your Stop Order Once Initial Order Profitable

Monitor your initial trades’ stop loss and once you’ve achieved a point where it’s unlikely you’ll be making a loss you should cancel your opposing correlated trade. The risk is now minimal and entry of the opposing trade could increase your risk now your initial trade position has worked as planned.

Manage Opposing Correlated Trades

Once you’re in your opposing correlated trade it’s a matter of testing how you want to get out, should you find yourself in both trades.

Here are some ideas to get you thinking on testing strategies:

Exit Once Initial Exits

You could look at exiting all trades once the initial trade exits. This would be the easiest way of managing this strategy and would alleviate any issues you may come across should the initial trade trigger another entry!

Apply Target or Trailing Stop

You could manage the opposing correlated trade in its own right by applying a target or trailing stop feature.

You would need to be mindful of your strategy possibly re-entering the original trade - if there’s an opposing highly correlated trade, do you worry about putting on another trade? What if the existing correlated trade ends up exiting during the second original trade? Ugh!

As you can see it can quickly become complex when the original opposing correlated trade has been managed in its own right.

In essence what we are doing is hedging our trades, and using correlation as the metric to determine which currency pairs to hedge our original trades. No strategy is a guarantee to remove all risk and losses from our trading account, but this article is to help you to understand how to employ more strategies to make you a profitable trader.

Conclusion

Hopefully this article has been beneficial to your understanding of hedged trades.

Of course, before implementing any new strategy into your trading method be sure to test it out on a few demo accounts.