December 8, 2022

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An explanation to currency pairs correlation

Several factors can affect currency correlation. For example, political stability, government debt level, GDP growth rate, the countries’ openness towards foreign trade are all factors that can influence currency pairs correlation. But before understanding how to use this information in the Forex market, one must understand what it is. 

What is currency pairs correlation?

Correlation is a qualitative measure that indicates whether two currency pairs move in the same direction or not. If both currency pairs move in the same direction, their correlation will be positive. If they move in opposite directions, their correlation will be negative.

How do you use currency pairs correlation with listed options?

Diversify your portfolio by using different currency pairs

Let’s say you’re trading the AUD/USD and USD/JPY currency pairs. Since we all know that correlation is a measurement of how two currencies move concerning each other, it will be beneficial to diversify your portfolio and trade more than one currency pair at a time. You should then sell options on the currency pair with a high positive correlation and buy options on the other with a high negative correlation.

Use listed options as insurance

If you’re upset about a particular currency, you may want to buy listed options on the corresponding currency pair. For instance, if you’re concerned that an Australian company’s stock price will decrease due to the slowing Chinese economy, it would be beneficial to purchase put options on AUD/USD since those two currencies have been highly correlated in the past.

Use different time frames when trading correlated currency pairs

When investing in listed options, pay close attention to how much time is left until expiration. If both of the correlated currency pairs are moving at similar speeds, one should consider switching to another trade with different timeframes.

What are the benefits of using currency pairs correlation in listed options?

Listing Options as Insurance

The listed options market is the only place where traders can buy and sell insurance for stocks. When there is a high likelihood that a stock price will fall or rise dramatically, traders usually look to purchase put and call options. This way, your potential upside increases, and you could make more money if the position moves in your direction. Have a look at the Saxo markets for more on this.

Diversify Your Portfolio

It’s easier than ever before to sell different types of options on correlated currency pairs since all trading platforms offer several asset choices for highly correlated currencies such as the AUD/USD and USD/JPY. However, investors should always consider using other non-correlated investments such as gold or oil when diversifying their portfolio because those instruments don’t have a high correlation level.

Different Time Frames Can Help You Identify Market Trends

Listing options on highly correlated currency pairs can be highly profitable for traders who have a fair amount of knowledge about how different time frames affect the price movement of different types of assets. If you’re aware that certain currencies move in the same direction at all times, then it would be wise to purchase put and call options on those correlated currency pairs with movements happening within similar or identical timeframes.

Find Profitable Trades

We all know that listed options become profitable once the price of an asset moves drastically in one direction or another. Since we know that currency pairs correlate with each other, it is best to buy and sell put and call options on those correlated currency pairs with movements happening within similar timeframes.

What are the risks involved?

Limited Gain Potential

The most significant risk of using correlated currency pairs with listed options is that you will not profit as much as you would if trading an uncorrelated pair. That means if you’re trading AUD/USD and USD/JPY, then both assets could move in opposite directions, but your gains will be diminished due to having purchased put and call options on both correlated currency pairs at the same time.

High Premiums Make It Difficult To Profit

Many traders who lack experience in trading highly correlated currency pairs tend to purchase put and call options on those assets with significant premiums attached. These option premiums can hinder profits because the premium will diminish the amount of money from your initial investment.