This segment is about correlation; what it is, what it means, how it is measured, what it can tell us and not tell us and how to use the TOS system to view correlation numbers. This information will give you access to tools that can aid your trading.
The measure used in statistics that indicates the linear relationship between two (or more) variables is called correlation. Correlation value ranges from +1 (perfect correlation) to -1 (perfect negative correlation). A reading of zero means exactly that. There is no correlation at all.
Two stocks with a high correlation have historically tended to move in the same direction. This though does not tell us why they have moved together or the size of the move. We use Beta to measure the size.
A TOS Watchlist and the details on how to add correlation to the watchlist was displayed as well as the ability to change the parameters of the correlation.
A table was displayed of the value and strength of the correlations breaking them down into strong positive, moderate positive, weak positive, strong negative, moderate negative and weak negative.
There are two important things with which correlation can help us. It can find non-correlated product which will diversify our portfolio (unlike the phony diversification of some robo-advisors). This will lessen the chance that we have a directionally over-weighted portfolio overall or in a sector.
The second thing is finding pairs trades. Pairs traders look for strong positive or negative correlations. When the pairs drift out of line the pairs trader will play them for a reversion to the mean.
Watch this segment of “Best Practices” with Tom Sosnoff and Tony Battista for information on how to best understand correlation and how to use the TOS platform to view correlation data.
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