Are You Doubling Your Risk Without Knowing It?

Understanding the relationships between currency pairs can be the difference between success and costly mistakes.

When trading multiple currency pairs simultaneously, it’s crucial to always be aware of your RISK EXPOSURE. Without knowing it, you could be doubling your exposure to the same market forces.

For example, trading AUD/USD and NZD/USD is like having two identical trades open because they usually have a positive correlation. You might think you’re diversifying your risk by trading in different pairs, but many pairs move in the same direction.

Risk Exposure

Instead of reducing risk, you are magnifying it! Unknowingly, you’re exposing yourself to MORE risk, a phenomenon known as overexposure.

Let’s take a closer look at an example involving two highly correlated pairs over a one-week period: EUR/USD and GBP/USD.

Currency Correlation Example: EUR/USD and GBP/USD

Here’s a correlation table for EUR/USD:

Pair1 Week1 Month3 Months6 Months1 YearEUR/USD-0.230.63-0.62-0.62-0.69GBP/USD-0.98-0.900.14-0.35-0.93

As seen in the table, there’s a strong negative correlation between EUR/USD and GBP/USD (correlation coefficient of 0.94), meaning they tend to move in the same direction.

Think of these two pairs as Ben & Jerry’s—they go together like peanut butter and jelly!

Both pairs share the U.S. dollar (USD) as the quote currency, meaning their movements are influenced by similar economic factors related to the U.S. economy.

Example 1: Going Long on EUR/USD and GBP/USD

Suppose you decide to go long (buy) on both EUR/USD and GBP/USD. If the U.S. dollar strengthens unexpectedly, both pairs could fall simultaneously, doubling your losses because the positions are highly correlated.

Instead of diversifying, you’ve increased your exposure to the same risk factor: the performance of the U.S. dollar.

To prove this, let’s look at their 4-hour charts:

EUR/USD and GBP/USD both moved in the same direction—down.

Doubling Risk by Trading Highly Correlated Pairs

Opening positions in both EUR/USD and GBP/USD is like doubling up on a position. If you buy 1 lot of EUR/USD and 1 lot of GBP/USD, it’s essentially like buying 2 lots of EUR/USD since both pairs move in the same direction.

This increases your risk exposure. If EUR/USD falls and you get stopped out, GBP/USD will most likely fall too, stopping you out as well.

Moreover, if you think buying EUR/USD and selling GBP/USD at the same time will diversify your risk, think again. If EUR/USD skyrockets, GBP/USD will likely follow suit, leaving you with no hedge.

Volatility and Pip Values

Even though EUR/USD and GBP/USD are highly correlated, they may not always move by the same pip range. Volatility within currency pairs is unpredictable.

For example:

EUR/USD could rise 200 pips, while GBP/USD only moves up by 190 pips.If you’re short on GBP/USD, you could lose more than you gain from EUR/USD.

This is why buying one pair and selling another highly correlated pair is counterproductive. Not only do you pay the spread twice, but you minimize your gains because one pair eats into the other’s profits.

Currency Correlation Example #2: EUR/USD and USD/CHF

Now let’s look at EUR/USD and USD/CHF. While these pairs seem different, they often show a strong negative correlation because the U.S. dollar is in different positions in each pair.

EUR/USD has a correlation coefficient of -1.00 with USD/CHF over one week, meaning they tend to move in opposite directions.

These pairs are like Tom and Jerry—they move in opposite directions.

When the U.S. dollar strengthens, it tends to rise against both the euro and the Swiss franc. But since the USD is the quote currency in EUR/USD and the base currency in USD/CHF, the pairs move in opposite directions.

Example 2: Going Long on EUR/USD and Short on USD/CHF

If you go long on EUR/USD and short on USD/CHF, you’re essentially doubling your position. If EUR/USD rises, USD/CHF falls, allowing you to profit from both pairs.

However, this also increases your risk exposure. If EUR/USD drops significantly, both trades may get stopped out, resulting in two losses.

Conclusion

Recognizing the correlation between currency pairs is crucial for managing risk effectively. If you’re trading highly correlated pairs, you may be inadvertently increasing your risk, not diversifying it.

Before making your next trade, double-check your exposure to avoid doubling your risk without realizing it.

Are You Doubling Your Risk Without Knowing It?

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