Many in the markets preach the importance of diversification but we have discussed several times how when the market moves down hard everything tends to move together. We strongly believe that correlation is a critical factor. We have previously discussed the importance of a low correlation for the underlyings in a portfolio (the closer we get to a zero correlation the better) but what about strategies? Are there strategies that we can use that have a low correlation to the market and or each other?
When holding the underlying constant can strategy diversification be effective at reducing our overall portfolio correlation? We ran a study testing individual strategies against holding stock and compared correlations of daily returns. Our study was conducted in the SPY (S&P 500 ETF) from 2005 to present. We compared different strategies using options closest to 45 days to expiration (DTE) and holding to expiration and compared these strategies to holding SPY stock. The strategies used were a Short 1 Standard Deviation Strangle, a Short Straddle, a Short at-the-money (ATM) Put and a Short Vertical Put Spread.
A table of all the strategies and their individual correlation to the SPY was displayed. The table also combined all the strategies together and correlated them to the SPY. The table showed that by combining all the strategies it lowered the correlation to .48 at order entry. Tom and Tony argued against choosing one strategy because doing so would not provide the right mix of a lack of correlation and for risk control. When combined together these strategies diversify your portfolio and mitigate risk from the movement of the underlying as especially compared to buying or selling stock outright.
For more on Correlation see:
Best Practices from March 9th, 2015: “Correlation”
Best Practices from October 19th, 2015: “Understanding Correlation”
Market Measures from November 17th, 2015 “Correlations and the Market”
Options Jive from February 29th, 2016: “Correlation | Is Your Portfolio In Trouble?’
Best Practices from May 2nd, 2016: “Four Facts About Correlation”
Watch this segment of Market Measures with Tom Sosnoff and Tony Battista for the valuable takeaways and the results fro our groundbreaking study on correlation of strategies to the market and each other.
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