Correlation, which is used frequently in trading, measures the historical relationship between multiple assets over a certain timeframe. What are the four most important facts about correlation to help you make trading decisions?
The first fact is the most basic. Correlation is a number ranged from -1 to +1 with a zero correlation meaning there is none, a correlation of 1 means there is a perfect correlation and a correlation of -1 means there is a perfect inverse correlation. The second fact is also about numbers. Correlation will not be constant. It can change over time, even for very highly correlated pairs.
The third is an offshoot of the second. When the market experiences a very large sell-off the correlations between stocks and their index (eg. the S&P 500) approach much closer to 1 and the inverse correlation between the SPX and the VIX will approach -1. When the sell-off is perceived to be over the correlations may snap back to previous levels. That brings us to our fourth fact. Correlation is a backwards-looking measure. It says with certainty what has happened in the past but may or may not indicate what will happen in the future.
For more on correlation see:
Market Measures from August 26, 2013: “Market Correlations: Bonds"
Market Measures from June 10, 2015: “Sectors: Correlations and Movements”
Market Measures from October 5, 2015: “Index Correlations”
Market Measures from November 17, 2015: “Correlations and the Market”
Watch this segment of “Best Practices” with Tom Sosnoff and Tony Battista for the important takeaways and a better understanding of correlation.
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