Correlation and Basket Trading

Course 29 of 60 in the forex hub. Hold three or four pairs at once and you may be holding one bet. Count the risk by currency, in dollars, before you add another ticket.

EURUSD + GBPUSD Is Often One USD Bet

Every currency pair is two currencies, and pairs that share one tend to move together. Long EUR/USD and long GBP/USD look like two trades. Underneath, both are short the U.S. dollar. If the dollar rallies hard against the euro and the pound together, both tickets can lose at once, so the real bet is one dollar position with two tickets on it.

Four or five pairs on the screen can feel spread out when they're really the same dollar bet several times over.

1. What a basket is

A basket is just a group of positions you hold at once. What matters is what they have in common. Write each pair as its two currencies and add up how much you're long or short of each currency in dollars. Long EUR/USD plus long GBP/USD comes out as long euro, long pound and short dollar twice.

Once it's written that way, the overlap is obvious. I add up the dollars at risk for each currency, and I check each leg's stop with the P&L calculator before adding them up.

2. USD factor

The dollar is on one side of most trades, so it's the factor that stacks up fastest. Long EUR/USD, long GBP/USD and short USD/CHF are three short-dollar tickets, because the dollar is the first name in USD/CHF.

Long EUR/USD risking $201 and long GBP/USD risking $201: if the dollar rallies hard, both stops can go together, so the dollar bet is up to 2 x $201 = $402. Cap that total, not each ticket.

Two hundred dollars each sounds modest. Four hundred on one idea may be twice what you meant to risk on it. When the dollar factor is full, a new dollar trade replaces an old one instead of adding to it.

3. EUR factor

The same counting works for the euro. Hold EUR/USD and EUR/JPY both long and you're long the euro twice. They differ on the other side, dollar versus yen, but if the euro drops on a policy surprise, both feel it.

So I count every currency in the book, not just the dollar. If two positions share a leg, they share a risk, whatever the pair names say.

4. How to cap

My cap is in dollars per currency, not per ticket. Add up lots times pip value for every position that's long or short a given currency, then compare that total with what you're willing to lose on that one currency. If it's over, cut the newest position or skip the next one.

Once a week I look at the book and cut the duplicate. If two pairs are doing the same job, the one with the worse spread or the uglier chart goes.

5. When one pair is enough

A second pair is worth having when it adds a different currency view. Pair a long EUR/USD with a short GBP/USD and you've got a bet on the euro against the pound, with most of the dollar netted out. That's a real second idea. Buying AUD/USD when the book is already short the dollar adds another short-dollar ticket.

The carry trade lesson has the same trap in another form: several high-yield pairs bought against the same funding currency are one trade, however many tickets it takes.

6. Basket mistakes I see most

Counting tickets instead of currencies. Assuming a correlation measured last year still holds this month. Adding a pair because it 'looks similar' to a winner, which is just doubling the winner. Ignoring that spreads and swap are paid on every ticket.

Next is the lesson on dollar index regimes, which looks at the dollar factor from the top down.

Measure correlation on the window you trade

Pairs that share a currency tend to move together, and some move in opposite directions. EUR/USD and USD/CHF often run against each other, so being long both is partly a hedge rather than a doubled bet. The only way to know how related two pairs are right now is to measure it.

Use the window you actually trade. A correlation over a year can look very different from the last month, and relationships change, sometimes quickly after a policy surprise. Recheck before adding a position you assume is unrelated to what you already hold. If you never measure it, you are guessing.

Trading three pairs at once

• Write every position as its two currencies and add up each currency in dollars.
• Cap risk per currency, not per ticket.
• A second pair earns its place only if it adds a different currency view.
• Recheck correlations on the timeframe you trade, because they drift.

If three tickets all win or lose on the same headline, you've got one trade. Educational only. Not a recommendation to buy, sell, or hold any contract or pair.