Four Important Aspects of Correlation
May 23, 2016
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 email@example.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.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
tastytrade content is provided solely by tastytrade, Inc. (“tastytrade”) and is for informational and educational purposes only. It is not, nor is it intended to be, trading or investment advice or a recommendation that any security, futures contract, transaction or investment strategy is suitable for any person. Trading securities can involve high risk and the loss of any funds invested. tastytrade, through its content, financial programming or otherwise, does not provide investment or financial advice or make investment recommendations. Investment information provided may not be appropriate for all investors, and is provided without respect to individual investor financial sophistication, financial situation, investing time horizon or risk tolerance. tastytrade is not in the business of transacting securities trades, nor does it direct client commodity accounts or give commodity trading advice tailored to any particular client’s situation or investment objectives. Supporting documentation for any claims (including claims made on behalf of options programs), comparison, statistics, or other technical data, if applicable, will be supplied upon request. tastytrade is not a licensed financial advisor, registered investment advisor, or a registered broker-dealer. Options, futures and futures options are not suitable for all investors. Prior to trading securities products, please read the Characteristics and Risks of Standardized Options and the Risk Disclosure for Futures and Options found on tastyworks.com.
tastyworks, Inc. ("tastyworks") is a registered broker-dealer and member of FINRA, NFA and SIPC. tastyworks offers self-directed brokerage accounts to its customers. tastyworks does not give financial or trading advice nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of tastyworks’ systems, services or products. tastyworks is a wholly owned subsidiary of tastytrade, Inc (“tastytrade”). tastytrade is a trademark/servicemark owned by tastytrade.
Quiet Foundation, Inc. (“Quiet Foundation”) is a wholly-owned subsidiary of tastytrade The information on quietfoundation.com is intended for U.S. residents only. All investing involves the risk of loss. Past performance is not a guarantee of future results. Quiet Foundation does not make suitability determinations, nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of Quiet Foundation’s systems, services or products.
Small Exchange, Inc. is a Designated Contract Market registered with the U.S. Commodity Futures Trading Commission. The information on this site should be considered general information and not in any case as a recommendation or advice concerning investment decisions. The reader itself is responsible for the risks associated with an investment decision based on the information stated in this material in light of his or her specific circumstances. The information on this website is for informational purposes only, and does not contend to address the financial objectives, situation, or specific needs of any individual investor. Trading in derivatives and other financial instruments involves risk, please read the Risk Disclosure Statement for Futures and Options. tastytrade is an investor in Small Exchange, Inc.