Correlation is the relationship between two or more variables with a range of negative (-1) to positive (+1). It is generally measured on a historical basis with a minimum of one month. Correlation measures the rate at which two stocks have historically tended to move in relation to their mean. If they are normally on opposite sides of the mean, they tend to move in opposite directions and have a negative correlation. If they are normally on the same side of the mean, they tend to move in the same direction and have a positive correlation. If there is no clear trend, they are said to have little to no correlation (0). Understanding correlation allows us to diversify our portfolio in non-correlated underlyings.
Positive correlation indicates that the two stocks tend to move in tandem, meaning that when one moves up, the other will typically move up as well. Positive correlation is measured on a 0.1 to 1.0 scale. Weak positive correlation would be in the range of 0.1 to 0.3, moderate positive correlation from 0.3 to 0.5, and strong positive correlation from 0.5 to 1.0. The stronger the positive correlation, the more likely the stocks are to move in the same direction.
Negative correlation indicates the stocks tend to move in the opposite direction of their mean. For example, when one stock is up, the other tends to be down. Negative correlation is measured from -0.1 to -1.0. Weak negative correlation being -0.1 to -0.3, moderate -0.3 to -0.5, and strong negative correlation from -0.5 to -1.0. The stronger the negative correlation, the more the stocks tend to be on the opposite side of their mean.
When two stocks have a correlation between -0.1 and 0.1 there tends to be no relationship between the movements of the stock. This indicates a minimal relationship, or no relationship at all. Based on the data, there is no clear trend with the movement of the underlyings.
Correlation can be helpful for managing our portfolio, but we have to be aware that when markets crash up or down, correlation can fall apart. With that said, it’s still important to keep it in mind when placing new trades. If we place 5 bullish positions in positively correlated underlyings, we don’t really have any diversity at all!
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