Currency Correlations Can Break Down

You need to be very careful about currency correlations, or currency pair correlations with some other market like the stock markets or a commodity like crude oil or gold.

There can be correlations between currency pairs and some equity index and commodity.  Many traders can link both trades together.

For example, someone could potentially go long AUD/USD and go long Gold at the same time.  There is definitely some global macro and order flow reasons for them to do so.  If the U.S. dollar is weakening because of slower U.S. growth, low interest rates, quantitative easing, then assuming there is still some risk appetite the market can both buy up AUD/USD and Gold at the same time.  Hence the correlation between the two begins to exist.

However, correlations can break down.  And when they do break down the pro traders take money from the amateur traders.  The pro traders realize that correlations can break down.  They are open to the possibility of placing trades that go against current established correlations.  The amateur trader always likes to trade with the correlations without thinking why they exist, or in what circumstances or scenarios they can break down.

When the correlations do break down, that is where a lot of money can be made.

Example:   AUD/USD huge drop begins on August 2nd, while the Gold decided to breakout to the upside.  If the amateur trader was strictly looking at the correlations and notice that AUD/USD is down while Gold is up, then the amateur trader could conclude that AUD/USD is mispriced and decide to buy.  The AUD/USD long trade would of lost a lot of money.  There was a situation where both Gold was rocketing higher and the AUD/USD was dropping precipitously.  Both gold and the U.S. dollar rallying simultaneously?  The amateur trader would be surprised.  While the pro trader knows that correlations can break down.

Example:  EUR/USD and Gold.  Gold was going higher, but EUR/USD was still stuck in a tight range.  Why wasn’t EUR/USD going higher along with Gold?

The key questions to ask about correlations from an order flow mindset are:

Why did the correlations, whether positive or negative, exist in the first place?  Was it pure coincidence?

Why did the correlations break down?  Where is the order flow coming from?  What is the thinking behind it?  Is it temporary phenomenon?  Or long term phenomenon?

What happened to the correlation order flow?

What will cause the correlation to come back into line?

What will cause the correlation to break down even further?

Those are the questions that if you can answer accurately will make you a lot of money.  The above are far better questions to spend time finding answers to than attempting to find moving average crossovers or MACD divergence across multiple time frames.

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