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# Correlation Analysis

Discussion in 'Strategy Development' started by bearmountain, Mar 1, 2010.

1. ### bearmountain

I was wondering if anyone has done research, building a trading stratergy around correlation analysis?

Tradestation has a correlation indicator which plots the value of two markets/stocks as follows, but I am not sure what to do with it. Would anyone have any ideas or point me to books/articles, i am interested in trigger to enter a trade and exit etc.

Market Synopsis

The Correlation indicator calculates the frequency of price movement in the same direction and in opposite directions for 2 markets during the number of bars specified by the input Length. This frequency is indexed and plotted as a value between 1 and -1. This is used as a measure of the tendency of two markets to move in the same direction.

A positive Correlation value indicates that the 2 markets tend to move in the same direction. A negative Correlation value indicates a strong tendency for the 2 markets to move in opposite directions. A Correlation value of near 0 indicates there is very little correlation between the two markets.

Among other applications, it is one of the core concepts behind pairs trading and statistical arbitrage. Look into some of the pair trading threads.

It is also a measure of diversification (portfolio, trading strategies, etc). Often you want to minimize correlation between the elements in those applications.

You guys spilling the beans here.

I've seen more profitable traders via concepts involving correlation analysis than any other method and pairs trading or statistical arbitrage aren't the only things that uses it.

Mark

4. ### bearmountain

Right thanks, pair trading/stat arb I believe relies on reverion to mean, that prices will return to historical norm. I was thinking if there is an edge in exploring correlation to generate a signal to enter and exit a trade.

so to study correlation between two stocks A & B or market sectors or stock A and its market sector. If X happens in the correlation analysis then enter, what would be this X condition?THanks.

5. ### Kedwards

For most, the X condition is when the spread gets Y standard deviations away from the normal (say 2 st. dev). Read this thread front to back and you'll have a good primer on correlation from a discretionary equities perspective:

6. ### JaiSreeram

Interesting examples:

(the secret is that there is no secret, but correlations and statistical fitness is the closest legit thing. stat arb is the case-in-point)

8. ### Martinghoul

Omigod, this thread must be deleted immediately and all the participants made to mysteriously disappear. Otherwise, what's next? The ultimate secrets of regression and basic statistics might just be revealed and where will we all be then.

9. ### henderson

Please stop it quickly before someone mentions cointegration!