Trading strategy based on the correlation of currency pairs
Many times we have talked about correlation and published its current values for various currency pairs, we have told you about the method of risk diversification when opening deals with instruments that have a correlation close to 1. In the 11th issue of ForTrader.org we will tell you about the possibility of a practical risk-free entry into the market for instruments with inverse correlation.
As an illustrative example, take the two currency pairs EURUSD and USDCHF. Correlation of these currency pairs is opposite, approximately equal to -1, i.e. if EURUSD moves in one direction, in most cases USDCHF will move in the opposite direction. In this strategy we will use the well-known fact that correlation has the characteristic property of changing over time, and does not have a stable valueIt gives an opportunity to make a profit when simultaneously opening trades in one direction for instruments with high inverse correlation, and the risk of loss will be very low.
Implementing a trading strategy on correlation
So, let's return to our trading tools. To implement the strategy, we simultaneously open two trades: on buying EURUSD and on buying USDCHF. Some of you will say that in this way we simply hedged positions, and they will not make a profit. In part, of course, this is true, but it is hedging that we will use to make a profit. The paradox is that we enter the market for instruments that have a high correlation without incurring losses, we wait for the moment when the correlation between them decreases, and both trades will give us profit. At this point, we close both orders and then look for an opportunity for a similar entry. That is all, just 4 actions: found, opened, waited and closed with a profit.
To make the meaning of the strategy clearer, here is sample operation:
As can be seen in Figure 1, two trades on EURUSD and USDCHF were opened simultaneously on September 19 at 19:45, when their correlation was closest to 1. Then their correlation began to decrease, and at the minimum profit the deals were closed at 8:46 on September 20. The main profit here came from EURUSD.
We continued trading by a similar method, and this time the USDCHF pair brought us the main profit (see Fig. 2).
Note that this strategy also has its pitfalls: profits may not quickly reach even the minimum value, and positions will hang in the hedge for quite a long time.
To demonstrate minimal risk work on the strategy, we left two positions, not fixing the minimum profit for several months, to make sure of the reliability of the hedging in this case. As we can see from Figure 3, the five-month trades remain open until this time and their total negative result is not large, only -4.90. In addition, the experts ForTrader.org magazine were able to earn extra money from swapI'm not sure how much I've accumulated over time.
To summarize
In its pure form, the strategy will produce a positive result. But note that due to the difference in the strength of the movement of the two highly correlated currencies, the result of hedging can reach a relatively high floating negative balance. This is especially dangerous if you misdirected trades and entered, for instance, to sell the two pairs indicated above and the Euro is rising more than the frank falls. In this case you will be protected by a less effective hedge. Therefore, when choosing a direction for transactions, you need to answer three questions:
1. Which currency pair is stronger at the moment EURUSD or USDCHF?
2. Which direction is the stronger currency pair going? Is it rising or falling?
3. What volume to trade on a less strong currency pair if the difference in strength of the movement is too great.
By answering them with reasonable certainty, trading on the strategy can be quite successful and profitable. Fans of "pipsing" strategy will especially like it.