Correlation Trading

Correlation trading in finance refers to the strategy used to find a statistical relationship between two different assets. It is mainly used to find the correlation between two stocks, currencies, commodities, or indexes. The sole purpose of this strategy is to determine the direction of the trend of the asset.  

The popularity of the correlation trading strategy originated in the mid to late 20th century. It paved the way for traders to diversify their portfolios by investing in not highly correlated assets. As a result, the overall risk faced in the financial markets is reduced to a greater extent.  

• Correlation trading is an investment strategy where traders analyze the relationship between two different assets simultaneously and determine their correlation coefficients.
• These assets can be from the same asset class or different categories, such as two stock market indexes, options and stocks, and gold and currency pairs.
• A correlation coefficient below 0 indicates a negative correlation, signifying an inverse relationship between the assets.
• Conversely, a coefficient equal to or greater than 1 represents a positive correlation. A coefficient of 0 indicates no correlation between the assets.

Correlation trading strategy refers to the strategy traders adopt to determine which assets have a positive correlation with each other. It acts as a tool to determine the relationship between two variables. Thus, traders can identify which two assets form a good pair and can yield good returns. For instance, this tool is useful in forex correlation trading to detect the best currency pairs. Likewise, the same procedure can also be applied to stocks and cryptocurrencies. 

Incorporating a correlation trading portfolio revolves around understanding the correlation coefficient. And this basis is further utilized in the different stock and index correlation trading strategies. Let us look at them:

• Empirical trading: As the name suggests, this strategy tries to understand the relationship between two assets in a historical market. In short, it considers past (historical) data and determines their correlation.
• Multi-asset options: The multi-asset options focus on correlating two or more options with an underlying asset. These options are also known as correlation options or rainbow options.
• Pairs trading: This method was pioneered in the 1980s by a quant group present in Morgan Stanley. Here, traders attempt to find highly correlated stocks. Once found, the next step is to sell the overperforming stock and buy the underperforming one.
• Structured products: This type of correlation trading portfolio defines the relationship between structured products and the underlying assets or indices they are attached to. It helps to understand which product can yield better returns compared to others. 
• Correlation swaps: In correlation swaps, the trader pays a fixed correlation rate to the seller (or receiver). However, in this case, no volatility or price components are involved.

Let us look at the mechanism or procedure of this strategy:

• Identifying the two variables (or assets): The first step in any index or forex correlation trading is to determine the type of asset dealt in. It is then possible to establish the correlation between the assets. So, if a person trades in the indices, they may consider the correlation between two indices like the Standard & Poor's 500 and Dow Jones Industrial Average. 
• Determining the correlation between them: Once the trader has successfully selected the assets as variables, the proceeding stage is to find the correlation between them. At this point, they may use the Pearson correlation coefficient formula to obtain the result. However, there are different interpretations of the values obtained. For instance, if the value is positive or equal to 1, it results in a positive correlation. It indicates a strong, direct relationship between the assets. So, if one asset rises (or follows an upward trend), the other asset will react the same and vice versa. However, if the coefficient is below 0, it depicts a negative correlation with an indirect relationship. It means that one asset may have a downward trend, but others may follow an upward trend. And for a value equal to 0 does not correlate the assets selected. 
• Deciding the trading strategy: As the correlation is established, the trader can then curate their trading strategy. Here, a trader can benefit from both positive and negative correlations. In short, some examples of correlation trading are buying assets at a downward trend and selling the upward trend or investing more in a trend. 

Let us look at some examples of correlation trading strategies to comprehend the concept in a better way:

Example #1

Traders can find correlation trading opportunities by monitoring the relationship between U.S. stocks and bonds, focusing on shifts in their correlation strength over time. U.S. stocks and bonds show a strong positive correlation, a trend not seen in years. This correlation's durability depends on the economy's trajectory. Analysts discuss potential outcomes in various economic scenarios.

For instance, U.S. Treasuries may gain value during a severe recession while stocks decline, leading to a negative correlation. However, this scenario is deemed less likely due to ongoing job creation and steady economic growth. The correlation between S&P 500 and Bloomberg Treasury index returns is currently high. This trend also offers trading opportunities; historical data suggests extreme correlations often revert. 

Example #2

Suppose an investor might notice that bond prices tend to fall when the stock market rises, indicating a negative correlation between the two assets. To capitalize on this correlation, the investor could sell short positions in bonds while simultaneously buying stocks. If the correlation holds true, any gains from the stock positions will offset losses from the bond positions, leading to a profitable trade. 

Following are the advantages and limitations of the correlation trading model. Let us understand them in a tabular format:

This article has been a guide to what is Correlation Trading. Here, we explain its examples, how to do it, advantages, and disadvantages. You may also find some useful articles here –

• Pairs Trading
• Directional Trading
• Dispersion Trading