Having the best possible understanding of correlation is a key differentiator for traders that want to access more advanced strategies.
The ability to identify and execute on brief windows of opportunity is a skill that pays off exponentially when the right market conditions present themselves - and the number of potential trades increases with knowledge of correlation.
A recent episode of Market Measures examined the topic of correlation involving a group of stocks and the overall market. The conclusions drawn from this research point to some key best practices - especially during selloffs in the broader equity market.
To get a better handle on this topic, the tastytrade research team conducted a study looking at the correlation between the top 100 stocks in the S&P 500 as compared to the overall index.
Through this effort, they tracked the average correlation and the one standard deviation range of this grouping through a period of market turbulence. The main takeaway from this research suggests that individual equities become increasingly correlated to the S&P 500 as volatility increases.
This phenomenon is illustrated in the graphic below:
Notice above that as the VIX spikes, so does the average correlation of the components within the broader index - indisputable proof that negative market sentiment has wide-ranging impacts.
The reason that correlations gravitate toward one during a sell-off is that the market enters a "risk-off" mindset and everything gets sold - with far less regard for quality and price.
The above means that investors seeking to diversify their portfolios may be somewhat short-sighted in deploying multiple positions across different instruments in the same asset class.
In order to achieve the goal of diversification, traders may instead need to deploy a variety of strategies - which actually offset each other during downturns.
For example, if two stocks have a strong correlation during a relatively non-volatile market, a trader may put both names in his/her portfolio with the hope that it may help diversify said portfolio.
Here's an example of a correlation chart:
However, if the market suddenly enters a volatile period, the realized correlation during that short period will likely be much higher than a historical metric derived from many years of data.
To compensate for these realities, traders can instead look to deploy a variety of strategies.
Constructing a portfolio in which a trader is short "expensive" stocks and long "cheap" stocks will likely represent much better diversification than taking two of the same directional positions in non-correlated products from the same asset class.
If nothing else, the financial crisis taught many traders the valuable lesson that sell-offs can trigger stronger correlations between products in the same asset class. As financial firms started to face considerable headwinds in 2007, market participants dumped these equities across the board, without regard for supposed "quality." This type of activity was observed in many other industries as well.
Today, we see that with oil prices dropping precipitously, the same type of behavior can be observed in stocks from the energy sector (particularly the oil and gas industry). In 2015, correlations in the energy sector have without question trended closer to 1.
These examples suggest that seeking diversification through a variety of strategies instead of a variety of stocks from the same asset class may be a much better way of maximizing returns while minimizing risk.
We encourage you to watch the full episode of Market Measures focusing on correlation when your schedule allows. Additionally, you can access more information on this subject by leveraging the search function on the tastytrade homepage.
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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.