This segment discusses correlation and how to use correlation figures to reduce risk. Diversifying amongst different asset classes will not lower risk if the correlation between the different asset classes is high.
Jacob Perlman, joins Tom Sosnoff and Tony Battista, as he begans the discussion with a brief explanation of correlation. A correlation will always be between 1 and -1. A correlation of 1 means the elements being measured move exactly together. A -1 correlation means they move exactly the opposite of each other. A zero correlation means they don’t move together at all.
The tastytrade belief is that staying small and trading often can result in reliable gains. The central limit theorem, which is at the heart of that belief, says that if you average n independent random variables, the standard deviation will go down by a factor of 1 divided by the square root of n. The problem is that when the random variables are correlated it is not quite right.
Understanding this, it is then easy to see what is wrong with trying to pick negatively correlated trades to reduce variance. Your variance goes down because you are taking both sides of a trades.
Of course most portfolios will consist of more than two underlying positions. We then need to explain this for multiple positions trades etc. Jacob explained average correlations and how they apply to this discussion. He further elaborated on the central limit theorem and explained why it is necessary not to just look for negative correlations but what to do instead.
Watch this segment of "The Skinny On Options Math" with Tom Sosnoff, Tony Battista and Jacob Perlman for a discussion of correlations and how to use them properly to reduce risk in your portfolio.