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How stock correlation could help you make better investment decisions?

How stock Correlation Helps You Make Better Investment Decisions

When investing, there are many factors and indicators that investors should consider to help them make better investment decisions. Some people enjoy relying on technical analysis (TA), analyzing charts for hours and making trading decisions based on the indicators shown on those charts. Other people enjoy doing fundamental analysis, checking a company’s quarterly earnings and making an informed decision based on the company’s performance and current valuation.

There are so many indicators and profitable investment strategies that it is tough to pick one strategy and remain loyal to it. No matter which investment decisions we make, it may be helpful to understand correlation, the correlation coefficient and how that information may guide us to make better investment decisions.

What is stock correlation?

According to the Miriam-Webster dictionary, correlation is “a relation existing between phenomena or things or between mathematical or statistical variables which tend to vary, be associated, or occur together in a way not expected on the basis of chance alone”.

Simply put, the statistical analysis between two variables shows how similar (or opposite) they are. In the stock market, for example, rising oil prices may correlate with oil companies increasing in price as well. We can also experience inverse correlations, where two different stocks go in opposite directions.

The famous example of inversely correlated stocks would be leveraged ETNs; with the TARK/SARK pair. When the ARKK fund goes up 1%, the TARK stock tends to  go up 2%, while SARK stock goes down 2%. If the ARKK fund usually goes down 1% and so on. 

In reality, the ETNs do not mimic the ARKK fund perfectly due to decay and management fees related to the ETN. But still, leveraged ETNs can allow traders to take advantage of significant price movements that occur within a short period.

How is correlation measured?

Correlation is obtained using the following formula:

stock correlation formula

Where x and y are the values studied for each variable.

The correlation coefficient is always between -1 and 1, with -1 being completely inversely correlated and 1 being completely correlated. If the correlation is 0, there is absolutely no correlation between the two variables.

In more general terms, two highly correlated variables tend to have a correlation index above 0.8, and two highly uncorrelated variables tend to have a correlation index between -0.2 and 0.2. These coefficients measured between many variables can help investors make better decisions through, understanding how the asset or share price is correlated compared to the overall market performance

What can we do with this stock correlation information?

 The stock correlation is most often used against one of the benchmark market indicators, such as the SPY or the QQQ. This way, investors can tell if a specific asset is correlated with the overall market or not. 

The SPY is considered a general benchmark index because it’s a basket of stocks with the most important companies in the US based on criteria like a minimum market cap and consecutive quarters of positive earnings. It may be interesting to look at stocks that are negatively correlated with the SPY during bearish times.

Looking at correlation coefficients is also useful when spotting sympathy plays. A sympathy play is when one stock in a sector booms, making other stocks in the same industry boom.

A great example of this is when the oil prices increased earlier this year when Russia decided to attack Ukraine: people could, of course, purchase oil and then sell it for higher, but many unprofitable oil drilling companies increased tremendously as well. Another great example is with HUSA stock, which was up over 500% intraday following the surge of oil prices in early March. 

Doing research, we could argue that when oil prices start increasing rapidly, there is a correlation with some lesser-known energy stocks that start surging quickly in value. Which stocks, however? Every time is different, so be attentive and be sure to invest with a plan!

Bottom Line

Stock correlation is one of many indicators that can help us make better investment decisions. However, like every indicator, no indicator gives the entire story and cannot be relied upon on its own to make a solid investment decision. Investors with the best track records tend to invest with a plan in mind, having done significant research and risk management before placing their order. Therefore, correlation is a great tool to add to an investor’s arsenal. Still, it is best used when combined with other tools and implemented in a strategy with a high chance of succeeding based on historical performance.

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