Currency markets are the backbone of the global economy, and banks are riding them like a bucking bronco. Banks don’t make money by speculating or trading in the currency markets, but by being in the currency market. What I mean by banks being a market is that they will make money whether you win or lose on a transaction.
This is because banks make money on the pips spreads on the front end, and they are always in a hedged position when it comes to a currency transaction. So it doesn’t matter what the market ultimately wins the banks regardless. Well, if banks are hedging their position to protect themselves, why don’t we as traders do the same?
Everyone has heard the term that for every action there is a reaction, and every negative has a positive, and what goes up must come down, you get the picture. Well, the same is true for the currency markets, which we refer to as hedging using negative correlations, or simply one pair goes up when another pair goes down and vice versa.
Anyone involved in the forex market needs to understand this basic concept of risk management. This technique is used all the time by banks and especially large multinational corporations that do business in currencies other than the dollar. It is simply a logical choice when trading multiple currency pairs to ensure that your trading account is not depleted very quickly.
Negative and positive correlations exist between all currency pairs and are prone to change based on various factors, and monetary policy in a country is one of them, if not the biggest. An investor should frequently check the correlation between currency pairs to ensure that there have been no major changes in the way currency pairs affect each other.
This can be done in some ways; most forex trading software packages include the ability to view historical and daily currency prices to determine the correlation between currency pairs. In conclusion, I highly recommend that if you trade currencies, familiarize yourself with the correlation coefficient between currency pairs to hedge your positions and limit your exposure to the market to maximize your profit.