Position sizing per trade is only half the risk picture. A trader who risks 1% on EUR/USD long, 1% on GBP/USD long, and 1% on AUD/USD long has technically risked 3%, but because these pairs are all USD-based and often move together, the real risk if the dollar rallies sharply can behave much closer to a single 3% (or larger) bet.
Understanding Correlation Coefficients
| Coefficient Range | Interpretation |
|---|---|
| +0.7 to +1.0 | Strong positive — move together |
| +0.3 to +0.7 | Moderate positive correlation |
| -0.3 to +0.3 | Little to no relationship |
| -0.7 to -0.3 | Moderate negative correlation |
| -1.0 to -0.7 | Strong negative — move oppositely |
EUR/USD and GBP/USD typically correlate around +0.85-0.90. EUR/USD and USD/CHF often correlate around -0.90 because CHF tends to move opposite to a strengthening dollar mechanically. Correlations are not fixed — they shift with macro regime, so recalculate periodically rather than relying on memorized values.
Portfolio Heat Formula
Portfolio Heat = Σ (Individual Trade Risk %) adjusted upward for pairs with |correlation| > 0.7 moving the same directional biasA simple practical approach: treat any group of open positions with correlation above 0.7 in the same directional bias as a single combined position for risk purposes, and cap that combined risk at your normal single-trade maximum (e.g. 2%) or a slightly higher group ceiling (e.g. 3%).
Worked Example
You open: EUR/USD long (1% risk), GBP/USD long (1% risk), AUD/JPY long (1% risk), USD/CHF short (1% risk). The first three are all effectively 'short USD' or 'risk-on' bets with high mutual correlation; the USD/CHF short adds to that same dollar-weakness thesis. Nominally 4% total risk is shown on your platform, but the effective directional exposure to a single 'USD strengthens' scenario could realistically behave like 3.5-4%+ concentrated risk, not diversified risk.
Opening five trades doesn't automatically diversify risk. If all five share a dominant driver (USD strength, risk sentiment, a single central bank), you have concentration dressed up as diversification.
Practical Portfolio Heat Rules
- ▸Cap total open risk (portfolio heat) at 5-6% of equity across all positions combined.
- ▸Cap risk in any single correlated cluster (e.g. all USD-based longs) at 2-3%.
- ▸Check a rolling 20-60 day correlation matrix before stacking similar directional trades.
- ▸Treat negatively correlated hedges skeptically too — they can reduce net exposure to near zero while still paying two spreads.