Trading in the market does not happen in a vacuum. This mantra applies to all investment markets; the usual suspects like stocks and commodities, but also Forex. There are a variety of events in any given environment that could affect the values items in any of these markets. The phenomenom we are looking at here though has to do with the effects the markets have on each other. Understanding these correlations will help you be more profitable at Forex Trading.
Big Investment people always talk about diversifying your portfolio. The idea is not to put all your eggs in one basket so you can keep going in case on thing doesn’t work out so well. You also hear about hedging. It’s an interesting strategy that involves taking a position in one market that is opposite to one taken in another market to offset any exposure to major risk…in a nutshell. One might look at this and work out that the net result would be zero, but savvy investors obviously expect to get out of the losing position quickly, and stay in the winning position for longer.
All of the above can be applied to the Currency Trading Market. I personally do not have an Account that allows me to invest in stocks or oil, but I can apply the trades I might have made in either of these markets to my Forex Trading. A simple example is the correlation between commodities and Australian Dollar, New Zealand Dollar and the Canadian Dollar. The the case of the Canadian Dollar, rising Oil prices help to increase it’s value against the dollar. This occurs because Canada is one of the World’s largest producers of Oil. It is also the largest supplier of Oil to it’s more popular neighbor, America. When Oil is on the rise, it is good for Canada, as much of Canada’s Economy depends on it. On the other hand, rising Oil prices are not so good for the US, also because much of the US Economy depends on it. Expensive Oil therefore tends to have a negative effect on US Equities. The end result is, you can trade the US Dollar/Canadian Dollar currency pair armed with this information.
One can extend this to other currency pairs. You can do some mixing and matching as well. Rising Gold tends to be good for the Australian Dollar and bad for the US Dollar, so one can buy the Australian Currency against the Dollar under such circumstances. Also, when US Equities are doing well, the Dollar tends to gain on the Japanese Yen because people would sell the Yen for Dollars so they can buy US Based Assets which offer a high rate of Interest than Japan.
The thing to note here is that this correlation is not absolute. There are times when it just won’t hold, when more important factors are at work, such as in a time of Economic strife when predictability in the markets reduces and everyone is afraid. These correlations will often reverse at a moments notice without much warning. This was the case in January 2009, when Gold and the Dollar began to move up at the same time. Some fundamentalists claim that there is no basis for the correlation between the dollar and Gold, for instance. Still, correlations like this can be quite useful. As a Forex Trader, you have to make use of all tools that come your way. I think there are times when it is best to go with the established trends. Like any other situation, the trader has to be constantly vigilant and pay attention to the surroundings. As long as you manage your risks accordingly, you will be able to stay in good shape, regardless of what happens.