Smaller tastyBITE sized accounts must be especially aware of correlation to protect themselves from an adverse market move that can damage their trading account. Correlation, as applied to equities, tells us when one stock moves up or down does another stock move in the same direction, the opposite direction or no particular direction at all. Two stocks that always move in the same direction will have a correlation of 1. Two stocks that always move in the opposite direction will have a correlation of -1. Two stocks that move in no particular direction to each other will have a correlation of 0.
A table showing 7 different levels of correlation from strong, moderate and weak for both positive and negative and a middle level of none to very weak was displayed Value ranges were provided for each level. Some mistakenly believe that causality lies behind correlation. That is not necessarily true. There can be a cause but sometimes there is no discernible connection. Others confuse magnitude with correlation. Beta measures magnitude. Correlation only measures direction.
Almost every market “expert” preaches the virtues of diversification. Some of these experts then go on to recommend diversifying a long position in SPY (S&P 500 ETF) by going long DIA (Dow Jones ETF). These two ETFs have a correlation of 0.97. As a graph shows they move together and there is no diversification by being long both. Using uncorrelated stocks and indices as the underlyings of our strategies will significantly reduce directional risk of the portfolio when selling option premium. Our goal is to choose underlyings with weak to no correlation (0.3 to -0.3): A table of the correlation of 7 of the most liquid underlyings was displayed. The table showed that underlyings that you might think had a strong correlation did not.
A table displayed the results of selling 30 Delta Strangles in two uncorrelated, ETFs (GDX & IWM) (0.01) and on two highly-correlated ETFs (GDX & SLV) (0.94). The trades were from 4/1/16 to 5/20/16. The Strangle in GDX performed poorly so as expected, so did the Strangle in SLV. The Strangle in IWM though performed well. The uncorrelated GDX/IWM combo was a winner while the correlated GDX/SLV combo was a loser.
For more information on the importance of Correlation see:
Options Jive from February 29th, 2016: “Correlation | Is Your Portfolio In Trouble?’
Best Practices from May 2nd, 2016: “Four Facts About Correlation”
Market Measures from May 31st, 2016: “Strategy Diversification”
Watch this segment of tasty BITES with Tom Sosnoff and Tony Battista for the important takeaways of a better understanding of the importance of true diversification, a diversification based upon correlation, can help keep you trading, especially in a tastyBITES sized account.
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