Correlation is a word that gets tossed around quite a bit in the financial media - often incorrectly. On today's blog post, we break this concept down into some smaller, more easily understood pieces.
My first real lesson on the practical application of correlation in options trading arrived during the start of the financial crisis in 2007. Early in that year, some of the US mortgage lenders started experiencing significant declines in their stock prices. They all dropped at once, signifying high positive correlation.
However, prior to the big sell-off(s) in equity markets, there were some pronounced upward moves in the prices of many commodities and associated industries. As you may recall during that period, the price of oil and coal were just a couple of the many commodity prices that screamed higher during the first phase of the financial crisis. Oil and coal had high positive correlation.
Watching and trading these symbols revealed a discernible pattern - these names were all tied at the hip from a business and stock movement standpoint. That’s correlation in a nutshell.
A recent episode of Best Practices takes up this exact topic and illustrates how traders can set up their trading software to view correlation.
On the show, hosts Tom Sosnoff and Tony Battista provide the definition of correlation, which is "a measure used in statistics that indicates the linear relationship between two (or more variables). The correlation range is between -1 and +1.
Correlation therefore tells us if two stocks have historically tended to move in the same direction, the opposite direction, or if there has been no linear relationship between the two. Obviously, the case for the global shippers from 2007-2009 was high correlation (closer to +1).
We should also note here what correlation does not tell us - which would be the causality (the reason behind it) or the magnitude (beta can be used for this).
So what is considered strong, moderate or weak correlation? The chart below can be used as a guide for interpreting degrees of correlation:
Another important question is: why we should care?
The reason is that a good understanding of correlation allows for additional deployment of high-probability risk in the options market - specifically pair trades, or diversification of a portfolio.
In terms of diversification, adding uncorrelated names to our options portfolio allows us to theoretically reduce the volatility of returns in our account.
If we have deployed the same structure in two underlying symbols that are highly correlated, we have effectively doubled down on that particular viewpoint. Deploying a similarly structured trade in a symbol that is negatively correlated to our existing position(s) will have a dampening effect on the volatility of our account’s returns. In this case, the trades will help offset each other - while hopefully both still contributing to profitability.
Following a group of correlated stocks can help a trader develop new skills and the ability to recognize opportunity in the market when it presents itself.
We encourage you to watch the full episode of Best Practices focusing on correlation when your schedule allows.
Additionally, we hope you will contact us at firstname.lastname@example.org if you have any questions or comments.
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.