To properly control risk one needs to be truly diversified but diversification is not just having positions in different underlyings. We must keep in mind the correlation of different positions. What is correlation and why it is useful?
Correlation describes the historical relationship between the changes in two variables. When used in trading it means how two underlyings move in relation to each other over a certain time period. A table of correlation ranges was displayed. The table included ranges from -1.0 (perfect negative relationship to each other), 0.0 (no relationship) and +1.0 (perfect positive relationship to each other). The 1-month correlations between SPY and USO as well as USO and TLT was also displayed. The SPY/USO correlation was a positive +0.54 while the USO/TLT was -0.38.
Correlation is not static. There is no guarantee that the current relationship will hold and non-correlated underlyings can quickly become correlated. You need to keep this in mind when adding to your portfolio. Two Iron Condors placed in two underlyings that have a weak correlation does not mean that both trades will not be losers. This is especially true in the event of a strong market move. A 1-year graph of the average correlation of a basket of stocks to the S&P 500 versus the VIX was displayed. The graph showed that as implied volatility (IV) increases or expands, so does the correlation of the stocks to SPY.
A screenshot of how to find correlations in dough and in thinkorswim was displayed. The screenshot showed how to find fixed correlations on dough and how to find the watchlist and configure it with correlation on TOS. The research team usually use a 90-day correlation. Tom noted the importance of knowing exactly where your portfolio risk lies. Tom said his long term goal was to give viewers an “instant assessment of risk” through technology.
Watch this segment of “Options Jive” with Tom Sosnoff and Tony Battista for the valuable takeaways and a better understanding of correlation and how to use it via our trading platform to reduce overall portfolio risk.
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