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Correlation Coefficient in Trading

Correlation Coefficient in Trading  


Correlation is a statistical comparison of the extent to which two variables move in relation with each other. In the context of trading in the financial markets, correlation shows the extent of the movement of a stock with a benchmark index, like the NASDAQ, or the relationship of movements of two stocks with one another. The factor of correlation is known as correlation coefficient, and the value ranges between -1.0 and +1.0.   

 

Correlation coefficient of +1.0 = perfectly positive correlation

  • Example: when one stock’s price moves either up or down, the second stock moves in the same direction. 

 

Correlation coefficient of 0 = no correlation 

  • Example: When one stock’s price moves either up or down, the second stock moves independently in no relation to the first one. 

 

Correlation coefficient of -1.0 = perfectly negative correlation

  • Example: When one stock’s price moves either up or down, the second stock moves in the opposite direction. 

 

Correlation coefficient is important to calculate because it can be used to create a diverse investment portfolio, which reduces the investment risk. Various software can be used to calculate correlation coefficient, and there is also a formula, which can be seen below.