A correlation trading strategy is an investment or trading approach that uses the relationship between the price movements of two or more assets to identify potential trading opportunities.
Correlation trading can be used for relative-value trading, diversification, and hedging, but correlation is not constant. Market conditions, economic events, and company-specific developments can cause previously correlated assets to move differently.
This article deep-dives into correlation as a concept and how it serves as a foundation for correlation trading strategy.
Key Takeaways
- The correlation coefficient ranges from -1 to +1 and indicates how closely two securities move.
- Correlation can be positive, negative, or zero.
- Pairs trading involves taking long and short positions in two correlated stocks.
- Cointegration tests and stop-losses are important because correlation might deteriorate over time.
- While active pairs trading requires skill and risk management, beginners can utilize correlation to develop intuition.
What is a Correlation Trading Strategy?
Correlation trading involves taking positions in two or more stocks based on how their market prices relate to each other, rather than on the fundamentals of individual stocks.
In trading, correlation is the measure of how the price movements of two stocks relate.
It is indicated by the correlation coefficient, which ranges from -1 to +1. The table below shows what different correlation coefficients mean:
| Correlation coefficient | Correlation type | Meaning | Example |
| Near +1 | Positive | Stock prices move in the same direction | Two banks, ABC Ltd and XYZ Ltd, have a correlation coefficient of 0.8. This implies that if ABC stock price increases, XYZ stock price might also increase, and vice versa. |
| Near -1 | Negative | Stock prices move in the opposite direction | The stock of the coffee company M and the stock of the tea company N have a negative correlation of -0.9. If the price of M increases, that of N falls, and the opposite is also true. |
| Near 0 | Unrelated | No consistent relationship between stock prices | Stocks of construction company MNO Ltd. and shoe company KPL Ltd. have 0 correlation. Therefore, an increase or decrease in the price of one will not affect the other. |
How Does Correlation Trading Work?
Step 1: Choosing associated securities
The investor shortlists securities that share positive or negative correlation due to a shared driver such as the same sector, index, or a particular macro exposure.
Step 2: Examining historical correlation
The correlation coefficient is calculated by analysing price data, usually spanning over a long period.
Step 3: Finding price divergence
The trader monitors the pair when movements begin to deviate from their pattern.
Step 4: Evaluating the divergence
The divergence is classified as either fundamental, resulting from a long-term change, or transitory, resulting from short-term noise.
Step 5: Entering and exiting the trade
If temporary, positions open with predetermined exit and stop-loss levels in anticipation of the relationship returning to normal. If the change is of permanent or long-term nature, the investor needs to revisit their strategy.
Types of Correlation Trading Strategies
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Positive correlation trading: An investor takes same-direction positions in two positively correlated securities when the shared driver turns favourable. For example, Mr X invests ₹5,000 each in two ice-cream company stocks as summer arrives, expecting both to move positively.
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Negative correlation trading: An investor takes positions in both inversely correlated stocks, such that if one falls, the other makes enough profit to balance. Mr Y invests ₹2,000 in ABC Tea Ltd., but as the share plummets, he invests ₹3,000 in KLM Coffee Ltd., so that its positive returns can balance the loss from ABC.
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Pairs trading: A type of market-neutral investment strategy that requires having a long position in the underperforming stock and a short position in the outperforming stock when their prices are moving differently from their normal correlation.
The intention here is to make money from any future convergence of prices toward the normal relationship. There are also multi-asset versions of this approach, in which the idea is applied to portfolios of correlated assets.
Correlation Pairs Trading Strategy Example
Consider TCS and Infosys, two of the biggest providers of IT services in India. They have had a strong positive relationship in the past and share revenue drivers such as US dollar billing.
If the sectoral demand projection remains intact, let's say Infosys stock prices surpass that of TCS over a few weeks following a robust quarterly report release.
As the market re-prices both companies in accordance with the sector, a pairs trader might short Infosys and purchase TCS, anticipating the gap to close. When prices realign, or a predetermined stop-loss is reached, positions close.
Real-World Indian Cross-Asset Pairs
Correlation trading isn't limited to two stocks in the same sector. It also plays out across different asset classes:
- USD/INR vs. Nifty 50: The rupee-dollar exchange rate and the Nifty have historically shown an inverse relationship at times of stress. Sharply weakening rupee has often coincided with a falling Nifty, as seen during the 2008 global financial crisis. That said, this relationship has weakened over time: rising domestic mutual fund inflows into equities combined with steadier FDI inflows have reduced how tightly the Nifty and USD/INR move together.
- Gold vs. equities: Gold and Indian equities have tended to show a low or negative correlation, especially during sharp market downturns. This is why gold is widely used as a portfolio hedge in India.
Correlation vs. Cointegration
Correlation and cointegration are often used together, but they measure different things:
Correlation shows how closely two assets move together over a certain period. It can change a lot depending on the time period you look at. But a high correlation doesn’t mean the two assets will stay close in price. Two assets can move in the same direction while the gap between their prices keeps getting bigger.
Cointegration looks at whether two assets tend to stay connected over the long term. Their prices may move apart in the short term, but they tend to move back toward each other over time. This is important in pairs trading because cointegration is different from correlation. Correlation only looks at whether prices move together, while cointegration looks at whether they maintain a long-term relationship.
Advantages of Correlation Trading
- Assists in revealing connections between assets that are not readily apparent from price charts alone.
- Since trades concentrate on relative performance, it can lessen reliance on forecasting the general direction of the market.
- Beneficial for relative-value strategies that take advantage of linked securities' mispricing.
- By demonstrating the true correlation of a portfolio, it can aid in optimal risk analysis and diversification.
Limitations of Correlation Trading
- Historical correlation may reverse as fundamentals change.
- Coincidence or brief data windows might provide false indications.
- Relationships may change due to shifting market conditions.
- Narrow margins might be weakened by transaction expenses and liquidity issues.
- Leverage and short-selling increase margin and the chance of loss.
How to Manage Risk in Correlation Trading
- Position sizing: Don't base leg sizes on the price of individual stocks, but rather on the aggregate risk of the pair.
- Stop-loss and exit rules: Establish ahead of time the divergence level at which you would close the trade to limit the risk.
- Leverage management: Exercise caution when using leverage since losses increase if the spread moves against both legs.
- Monitoring validity: To make sure the connection is still valid, frequently recalculate correlation.
- Transaction costs: Take the expenses and costs related to the trade into account while judging its suitability. Consider the impact of taxes, brokerage, etc.
- Historical data: Use historical correlation as a suggestion rather than a guarantee.
Is Correlation Trading Suitable for Beginners?
Even beginners can benefit from understanding correlation, as it helps with fundamental risk assessment and diversification and develops intuition about how correlated stocks move together.
More complicated, active correlation or pairs trading requires proficiency with statistical analysis, short selling, and simultaneously managing two positions. It also requires the self-control to adhere to rules and strategies set rather than investing emotionally.
Those who are unfamiliar with the approach usually begin with paper trading or backtesting in addition to risk control measures like position limits and stop-losses.
Conclusion
A correlation trading strategy uses the statistical link between assets to formulate trades. Strategies like pairs trading are built around relative rather than absolute price movements of related stocks. Correlation trading promotes diversification, hedging, and relative-value opportunities. Historical correlation necessitates regular inspections, cointegration analysis where appropriate, and careful risk management before actual capital engagement.
