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May 23, 2016

Four Important Aspects of Correlation

By:Sage Anderson

Correlation is one of the most important concepts to understand in the financial/trading industry.

An understanding of correlation can often equate to a better understanding of the underlying reason that a market or security is moving in a particular direction.

For example, it's been clear over the last couple years that global equities have been highly correlated to the price of oil. As oil plummeted from above $100/barrel down to the $20s, equity markets also temporarily dipped due to the accompanying uncertainty of a steep sell-off in one of the world's best known commodities.

Worldwide equities only staged a comeback when oil rebounded from roughly $26/barrel to over $40/barrel due to supply coming offline and rumors of a coordinated "freeze" in production by the world's largest producers.

As noted in a recent episode of Best Practices, correlation (in terms of the investment industry) is defined as the measurement of the historical relationship between two or more assets over a set period of time. Correlation basically tells us to what degree asset prices move together.

It's important to note that correlation can be both positive and negative. A positive correlation exists when asset prices move in the same direction. A negative correlation exists when assets prices move in the opposite direction.

The slide below illustrates graphically the positive correlation between MasterCard and Visa as well as the negative correlation between the SPY and VIX:

The Best Practices focusing on correlation highlighted four other important aspects:

1. Correlation is a number between -1 and 1. Negative 1 indicates the highest possible negative correlation, while positive 1 indicates the highest possible positive correlation.

2. Correlation is not constant. The correlation (or lack thereof) between assets changes over time.

3. Assets become more positively correlated when markets crash. During times of economic stress asset prices tend to move more similarly as the market seeks direction.

4. Correlation is a backward looking measure. Correlation only tells us how asset prices have moved in the past. It doesn't tell us why they moved together, or whether this relationship will hold in the future.

 

The full episode of Best Practices focusing on correlation contains additional examples that help illustrate the four points made above.

We hope you'll take the time to view the episode in its entirety.

If you have any questions on correlation, we hope you'll reach out to us on email via support@tastytrade.com

As always, we look forward to hearing from you!


Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.


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