One of the major position-sizing errors made by Forex Traders using a multi-currency pair system is failing to take correlations into account. Just as no man is an island, nor is any currency. (Especially in today’s world.)
Imagine you have a number of long USD positions against different currency pairs. Now imagine a news release sparks a selloff. (Remember the FOMC meeting last month?) You won’t just lose once as the bottom falls out of the greenback. You’ll lose as many times as you have positions.
Of course the market may correct, and of the greenback will recover. But you’ve been stopped out in the meantime.
Correlation gets complicated quickly. Put simply, it just means that a single factor can move many pairs at once. This can be great, or devastating, depending on which end of the trade you hold. But when trading, first you should think about risk management and then think about profit.
As you can probably tell, it pays to be aware. While the USD example above may seem obvious, correlations happen across different currency pairs too. You can view correlations across a number of majors and exotics here. Note that the relationship between currency pairs changes, depending on the timeframe(s) you consider.
Also note that some positions are inversely correlated, meaning they tend to move in opposite directions to each other.
Correlations make selecting your system’s currency pairs critical to how you construct your position- sizing algorithm. If you want to hold multiple correlated currency pairs, then you may need to trade smaller sizes than you would if you were to hold a limited number of less correlated instruments.
One way of doing this is to limit the percentage of open risk per group of correlated pairs to a set amount, such as 3%. In other words, no matter how many times you are long or short a certain currency, a disaster can never cost more than 3% of your account.
Some traders, such as Jim Langlands, choose to focus on a smaller basket of currency pairs as their method of managing correlations. If trading less pairs suits you, you can pick and choose the ones you’re comfortable with, and that won’t turn on you all at once.
This is where it can be useful to add markets outside of Forex (such as indices and commodities) to your basket. But remember, there is no guarantee that an index or commodity is not correlated with a currency pair or two.
There’s no escaping correlation, so the sooner a trader wraps their head around it, the sooner they can avoid its negative effects. Correlation is central to risk management, which means it is central to good trading.
How do you plan to work correlation control into your system?
About the Author
Sam Eder is a currency trader and author of the Definitive Guide to Developing a Winning Forex Trading System and the Advanced Forex Course for Smart Traders (get free access). He is a co-owner of Forex Signal Provider FX Renew (Get a FREE 30-day trial). If you like Sam’s writing you can subscribe to his newsletter.