Traders and investors use different trading strategies to sharpen and bring accuracy to their trading decisions. One of the trading strategies that can assist traders and investors in identifying a trend is correlation, which is a statistical measure of the comparative movement of two securities.
Correlation trading strategy is an objective measure of the movement of two securities or assets, based on their historical data. By being able to identify the degree of correlation between the two securities, a trader can preempt the movement of one asset based on the movement of the other asset.
By properly understanding and accurately reading this statistical measure, traders get a competitive edge in making informed financial decisions that align with their investment objectives and risk appetite. The correlation strategy helps traders by providing them early signs about the movement of an underlying asset, thus creating opportunity for profit and also warning about potential losses.
The correlation between the two securities can be either positive, negative, or there could be no correlation. The correlation coefficient ranges between -1 to 1. The positive correlation, which has a coefficient above zero, means the two securities historically move in the same direction, signaling that the two of them will likely continue to move similarly in the future also.
The negative correlation, which has a coefficient below zero, means the two securities move in the opposite direction, signaling the likelihood of the continuity in that comparative trend in the future also. The no relation, which has coefficient of zero, would mean that the two securities have moved indifferently to each other and their movements are relatable, thus the two of them should not be viewed comparatively for any analysis.
Read More About What is Implied Correlation Trading Strategy?
How to Calculate Correlation?
Before going any further, it is important to understand the correlation coefficient. The correlation coefficient is a measure between -1 to 1 (or -100% to 100%), which indicates the extent of correlation between the two underlying securities. In the case the correlation coefficient would be 1 (100%), it would mean full similarity in the directions of the two securities, while -1 (-100%) would translate into the completely opposite direction between the two securities. If the result is anything between -1 (-100%) to 1 (100), it would indicate the degree or percentage to which the correlation is either positive or negative.
Here is a detailed breakdown of how you can calculate correlation coefficient between the two securities.
Correlation Coefficient (r) = (n * Σxy – Σx * Σy) / √[(n * Σx² – (Σx)²) * (n * Σy² – (Σy)²)]
Where:
n is the number of data points,
Σxy is the sum of the products of each x and y value,
Σx is the sum of all x values,
Σy is the sum of all y values,
Σx² is the sum of the squares of the x values,
Σy² is the sum of the squares of the y values.
How to Use Correlation Trading Strategy?
You can use the correlation trading strategy in multiple trading scenarios. One way to use correlation between two securities is when the momentum of one of the securities would change. It will help you in preempting the price momentum of the other underlying security, providing a forecast about its price movement in the future.
If it is a positive correlation, it signals that the other asset would also follow the same trend and you can accordingly make the investment decision. In case it is a negative correlation and one of the securities has a change in momentum then the other asset is likely to change momentum in the opposite direction.
Therefore, correlation assists a trader in preempting a trend and making an informed investment decision of buying or selling the securities to make maximum profit. For example, the US dollar and gold have a negative correlation, which means when the dollar is strong, the gold value decreases, and vice versa. By monitoring the strength of the dollar, a trader can preempt the direction of gold-related securities.
It is, however, advisable that correlation, like all technical indicators and measures, should not be considered in isolation. It is always wise to use multiple indicators and measures before making any investment decision.
Here is a step by step breakdown of how to use correlation trading strategy.
- You must first identify the two securities or variables which you want to monitor or invest in. You can choose securities of the same class and category, or indices, commodities, or stocks.
- You should then determine the correlation between the two securities and find out how much positive or negative they are on the scale of -1 to 1.
- You should then track the momentum of the two securities to preempt a trend and then make your trading decision. You can sell the securities if you see the possibility of a downward trend or buy the securities if you see the possibility of an upward trend.
Know More AboutLogic of Pair Trading
Types of Correlation Trading Strategies
Based on the correlation measures, traders can utilise various trading strategies to preempt stock movement and make efficient trading decisions.
Empirical Correlation Strategy
It studies the historically significant correlations within or between financial markets.
Pairs Correlation Strategy
It is based on historical correlation between two securities and compares a long position with a short position in two stocks with a high correlation.
Multi Asset Options Correlation Strategy
It correlates two or more options, known as correlation options or rainbow options, with an underlying asset.
Structured Products Correlation Strategy
It seeks a comparison between a structured product and its underlying assets or indices.
Conclusion
Correlation is one of the ways in determining the direction of a trend, which can become a crucial factor in securing profit in trading. The traders and investors need to understand the nuances of the correlation trading strategy and how it can be implemented to maximise gains. However, the traders need to remain vigilant that correlation alone should not be the determining factor in their trading decisions.
FAQs
What is a correlation trading strategy?
A correlation trading strategy is to correlate the historical data of two securities which helps establish a pattern in their mutual behaviour. This correlation then helps traders in determining trends.
What is a positive and negative correlation?
A positive correlation means when the two assets under comparison follow the same direction in the past. The negative correlation means the two underlying assets follow opposing directions in the past.
What are the key advantages of correlation trading strategy?
The correlation trading strategy benefits by providing a scope for portfolio diversification, preempting the trends, helps determining undervalued and overvalued stocks, and aids in arbitrage.
What are the key disadvantages of correlation trading strategy?
The key disadvantages of correlation trading strategy is that it is difficult to calculate the correlation coefficient and certain market factors can influence the results.
What is the purpose of correlation trading strategy?
The main purpose of the correlation trading strategy is to determine the trends.
