We talk about correlation often at tastylive.com because it is one of the foundations of Modern Portfolio Theory, i.e. reducing risks within a portfolio by trading stocks that have little correlation with one another. Explained simply, correlation is a measure of the extent to which two underlyings move together (or apart) directionally. We explain this important measure further in this Best Practices.
Traders specifically use correlation to:
Use #1: Correlation is measured between -1 and +1 A strong positive correlation corresponds to two securities moving up and down together, while the opposite means the two move apart consistently. Correlations near zero should be disregarded. For diversification purposes a correlation close to 0 between two underlyings is ideal -- it means that your portfolio will better weather the storm during large moves.
Use #2: Correlation is dynamic The correlation between two underlyings changes on a daily basis; no relationship should be taken for granted. Anyone looking at the relationship between bonds and stocks has seen this -- for many years it has been negative, as one moves up the other (most often) moves down. But recently this relationship has turned positive.
Use #3: When the market sells off and volatility spikes, the individual stocks in the S&P 500 start to trade similarly This is what makes true diversification so difficult: stocks become more positively correlated in market selloffs.
Use #4: Options strategies also exhibit correlations This is an important concept and something all option traders should be aware of: not only can underlyings display correlations, but so can option strategies.
Use #5: Correlation is a backward-looking measure Correlation measures the recent historical relationship between two securities. This relationship should not necessarily be expected to continue into the future.
Watch the segment to get more of Tom and Tony's take on this important concept.
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