Friday, January 31, 2014

Correlation: The Unsung Indicator

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.

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