Traders use a combination of fundamental and technical analysis to understand price movements of securities and how certain stocks perform vis-a-vis others. An important aspect of technical analysis is the use of formula and indicators. One such is the Spearman rank correlation.
What is Spearman rank correlation?
Spearman rank correlation, also known as Spearman coefficient is a formula used to identify the strength of the link between two datasets. This coefficient is a method that can be used to assess the strength of a relationship apart from the direction it takes. The formula, named after Charles Spearman, a mathematician, can only be used in circumstances where data can be categorised or put in order, for instance, the highest to the lowest.
For a better understanding of Spearman coefficient, it helps to get a sense of what monotonic function means. There’s a monotonic relationship under these circumstances:
- – When the variable values rise together.
- – When one variable value rises the other variable value lowers.
- – The rate of movement of the variables need not necessarily be constant.
The Spearman correlation coefficient or rs, between +1 and -1, where +1 indicates a perfect strength between variables, while zero shows no association and -1 shows a perfect negative strength.
Pearson vs Spearman coefficients
There is also the Pearson coefficient, wherein the linear correlation between two variables is measured. The Pearson coefficient is always used only in linear relationships between two variables. Also, in the Pearson coefficient, the variables increase at a constant rate.
Yet another difference between Pearson coefficient and Spearman correlation is that while the former can work with data that is raw, the Spearman coefficient works only with variables that are rank-ordered.
When to use Spearman rank correlation?
When a scatterplot indicates that the relationship might be linear or might be monotonic, it would be best to use Spearman. Pearson coefficient will not work if data is not linear or perfectly so. On the other hand, Spearman coefficient will not do any harm even if the data is linear or perfectly so.
What is the role of a Spearman indicator in the stock market?
Spearman coefficient has many applications and is used in stock market technical analysis. It helps in assessing strength of a trend or turning points. The coefficient was popularised by noted trader Dan Valcu for use in technical analysis.
The Spearman indicator in the stock market can be used to understand the correlation between a strong trend and the price changes.
The Spearman ratio (two datasets and their ratio) is multiplied by 100, wherein +100 is indicative of strength of correlation with an uptrend while -100 is that of a strong downtrend correlation.
The two datasets typically used while applying the Spearman correlation are: actual prices and a sorted list of that series. The correlation can be used to compare a security’s volatility with a price trend that’s efficient.
The Spearman rank correlation values above +80 could be an indication of tops while the values below -80 could be indicative of lows or a negative trend. The values of +100 or -100 are extreme and are not recorded often.
Spearman indicators can also be used to assess the levels at which you can place a stop-loss order.
Oscillator indicators and Spearman
Oscillator indicators play an important role in trading, as they help you identify oversold or overbought conditions. An oscillator is a technical analysis tool that shows variations over a period of time within a specific band. There are several oscillator indicators and the Spearman indicator is one such oscillator. Oscillators come in handy when the market is choppy and no specific trend seems to be emerging. An oscillator such as a Spearman indicator in the stock market provides a clearer picture of the action and gives you buy or sell signals. Oscillators are typically used in a sideways market where the price action oscillates across a horizontal channel.
Technical analysis involves a range of tools that help a trader assess price movements and when to buy or sell. One of the most important technical analysis tools is an oscillator that indicates any overbought or oversold market condition. The Spearman rank correlation or indicator is a key tool that can be used to assess market trends. It can be used in association with other tools so as to get a clear picture of the market, as no technical tool or oscillator indicator can function as a standalone tool for market analysis.