Correlation analysis is a way to measure the degree to which two stocks tend to move in the same direction at the same time. It is an important analysis for investors who want to build a diversified portfolio that can withstand market shocks and for traders who want to spot opportunities or hedge against risks.
In this guide, we'll explain what correlation means in the stock market, why it's important, and how to analyze correlation between stocks.
What is correlation in the stock market?
Correlation is a quantitative measurement that describes whether two stocks are moving in the same direction at the same time.
If two stocks gain 10% during the same 30-day period, they are considered highly correlated during that period. If one stock gains 10% on a steady rise and the other fluctuates between +2% and -2%, then those two stocks are considered uncorrelated.
While it is sometimes easy to see on a price chart that two stocks tend to move together, monitoring price movements is imprecise at best and inaccurate at worst. Correlation analysis provides a way to measure how closely the movements of two stocks are related.
The most common measure of correlation is the Pearson coefficient, which ranges from +1.0 to -1.0.
- Coefficient +1.0 It indicates that two stocks are perfectly correlated – they always move the exact same amount up or down at the same time.
- Coefficient -1.0 It indicates that two stocks are completely inversely related – for every one stock gains 1% in a given time frame, the other stock will lose 1%.
- Coefficient 0.0 It indicates that the two stocks are completely uncorrelated.
Note that a positive correlation does not necessarily mean that prices are rising. There can also be a positive correlation between two stocks if they both experience price declines at the same time.
Types of correlation in the stock market
While many traders and investors use correlation analysis to measure the relationship between two stocks, this type of analysis can be used to uncover relationships between any two variables. For example, you can measure the correlation between a single stock and the S&P 500. You can also measure the correlation between a stock and a commodity — for example, between an oil company's stock and the price of oil. Or between a stock and an index – for example, between a “safe haven” stock and the VIX index.
Correlation and causation
The important thing to remember when discussing correlation is that correlation does not equal causation. Knowing that two stocks are related doesn't tell you anything Why This link exists or whether it will continue.
There may be a correlation between two stocks because they are affected by the same market trends or macroeconomic events. Or they may be related because the same large investor owns shares in both companies. Further analysis is needed to determine why the association exists and whether it will continue in the future.
Why is stock correlation analysis important?
Correlation analysis in the stock market is important for both investors and traders. Here are some of the main reasons to use correlation analysis.
Portfolio diversification
Investors typically seek to build a diversified portfolio to manage investment risk. For most investors, the term “diversification” includes investing in stocks that have a low correlation (positive or negative) with each other.
If the stocks in a portfolio are highly correlated, investors could see their entire portfolio sink at the same time. On the other hand, if the portfolio contains stocks with low correlation to each other, it is likely that some stocks will gain value at any given time even if others lose value.
Find trading opportunities
Traders can use correlation analysis to find stocks (or groups of stocks and indices) that are closely related or inversely related. If two stocks are highly correlated and a trader sees one of them rising, he or she may expect the other stock to rise soon as well and open a long position.
However, traders cannot use correlation blindly. It is important to determine why the association exists in order to predict whether this association will be valid during the current movement.
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Hedging against risks
Traders and investors can also use correlation analysis to hedge against market risks. Suppose a trader has a large long position on a cryptocurrency mining stock, the price of which is closely linked to the price of Bitcoin. Knowing that this correlation exists, a trader can also buy put options on Bitcoin to hedge his position in the event that the price of Bitcoin declines – and potentially the price of his cryptocurrency mining declines.
How to calculate correlation between stocks
It is possible to calculate the Pearson coefficient for two stocks manually. However, this is time consuming since you need to compare the price change of each stock over dozens or hundreds of time periods. Most investors and traders rely on tools to automatically calculate correlation.
There are many free online tools that allow you to enter the indicators you want to analyze for correlation and choose your own time interval:
Investors who want help building a diversified portfolio may want to consider a paid tool like Morningstar Premium. Not only does this provide correlation analysis for the stocks in your portfolio, it also helps you achieve diversification by helping you visualize the overlap between the individual stocks you own and the stocks you hold in ETFs and mutual funds.
When analyzing multiple stocks, correlation coefficients are often shown in a matrix. This allows you to quickly view the correlation between many different stock pairs at once rather than calculating correlations one by one.
Use correlation analysis to create a diversified portfolio
To give an example of correlation analysis in practice, we will consider building a small portfolio of stocks. To get started, we'll include 7 stocks from several different sectors:
- Camel
- TSLA
- General Electric
- snake
- XOM
- FDX
- TGT
These stocks are relatively uncorrelated, but TSLA and XOM have a correlation coefficient of 0.64. XOM also has a correlation coefficient of 0.54 with FDX. Therefore, we will replace XOM with other stocks from a different industry to achieve greater diversification.
Keep in mind that correlation analysis is just one part of building a diversified portfolio. Investors also need to consider performance, value, growth potential, and more. Correlation analysis should be used to double-check the portfolio to ensure it meets the diversification needs of the investor, but it should not be the driving factor when choosing which stocks to buy.
Conclusion: Correlation analysis in the stock market
Correlation analysis is a way to measure how closely the price movements of two stocks are related. Investors may want to avoid high correlation when building a diversified portfolio, while traders may seek correlation to spot trading opportunities. Traders and investors alike can also use correlation analysis to identify opportunities to hedge market risks. Keep in mind that it is important to understand the reasons why two stocks are related when making trading and investing decisions.
