One of the real
undiscovered jewels in MetaStock is the correlation analysis tools. In a
nutshell, correlation analysis lets you see how closely two instruments move
together. For example, two stocks that move together in lockstep by the
same magnitude will have a high correlation coefficient. A value of +1
means a perfect positive correlation exists between the two stocks. A
value of -1 is a perfect negative correlation. Generally speaking, values
above 0.7 indicate strong positive correlation and values below -0.7 indicate
strong negative correlation.
Correlation analysis is
used by long-term investors wanting to diversify a portfolio. In
general, investors will seek asset pairs that are negatively correlated such as
Gold and the US Dollar Index. Short-term traders use correlation
analysis to do what is called pairs trading sometimes referred to as
convergence trading. For example two highly correlated stocks are monitored for a temporary divergence where the spread widens with correlation turning negative. Traders will put on positions that profit when the two
stocks converge back to normal positive correlation ranges.
The daily chart below shows
such a situation between two stocks that typically have high positive
correlation, Coke and Pepsi. Pairs traders would attempt to use simultaneous
long and short positions to profit when the two diverge with negative
correlations--such as the November-December 2010 timeframe--and subsequently
revert back to positive correlation. Pairings between stocks within the same
sector are often used for these trades (i.e., Walmart and Target, Exxon Mobile
and Chevron, etc). Note when overlaying instruments as shown in the MetaStock chart below, it is a good idea to change the y-axis scaling for both
instruments to semi-log so that the magnitude of movement is comparable.
Now look at the 1-minute
chart of Coke and Pepsi below. Notice at this shorter interval over this particular time span, the periods of negative correlation are more frequent offering more
short-term opportunities to exploit (i.e., around the 12:30 PM point on the
28th).
The chart below shows
two instruments that are often negatively correlated, Gold and the US Dollar
index. A pair like this can offer long-term investors good
diversification for their portfolio.
The next chart below
shows the the Dow Industrials ETF (DIA) and the S&P 500 ETF (SPY) and a 50
day correlation indicator. As expected these are very highly correlated.
Trading opportunities come when the correlation temporarily weakens as in
the April 2011, April 2012, and November 2013 timeframes.
Pairs trading is just
one example of how the correlation analysis tools in MetaStock can help your analysis. Correlations between options and their underlying
instrument are popular to track. And of course using commodity traders
can use correlation with spread trading between contracts (i.e., Live Hogs and
Corn).
But one thing for sure, Correlation is one of the unsung indicators. So give it a look.