Using stock correlations for day trades

Discussion in 'Technical Analysis' started by boddintrader, Nov 3, 2012.

  1. Does anyone use correlations between stocks and indexes to day trade? This could be a market index or ETF. This could also be sector index or ETF.

    My general trading is mostly to focus on the technical pattern of a stock and use the various inflection points for entries and exit.
    If I'm day trading an energy stock, I'll usually look at the market (SPY) and sector (XLE) for help with the general direction. That is, if I'm looking to short the stock, I'll check for market and sector weakness ahead of taking the position. But other then a check for a few down bars, general trend, or an upcoming inflection point, I don't do much with this.

    So I've been trying to figure out how I can use the market and sector more to my advantage. The general idea is that markets move sector, and sectors move stocks, but is this true in day trading? Would I find more high-probability opportunities if I were trading stocks with high market and sector correlation?

    What are some of the general rules that you use for correlation? What time frame do you use for measuring correlation? How many periods? What's your threshold for "high correlated"?

    My research on correlation points to a 20-day correlation of above .80 being "highly correlated." Not sure how others came up with 20 days. TradeStation's correlation indicator has a 14 period default, which doesn't make any sense to me. Not sure if using daily charts for correlation is useful for day trading. I've used MetaStock to measure correlations on 5-minute charts for 78 (1 day) and 234 (3 days) periods. Not sure if that's any better.

    I appreciate any thoughts, feedback, research or links to more information.
  2. mutluit


    FYI: Pairs Trading uses a similar methodology:
  3. Quick clarification, the hypothesis I'm investigating is whether or not I can use the market or an ETF as a leading indicator for a .15-.30 move in a stock.

    I appreciate the feedback and link, but I'm not heading down the pairs trading road on this one.
  4. toc


    A good thread!

    However to day trade, you are more interested in intraday Corelations not daily.

    There is high daily corelations between Oil i.e. XOI and OIH with least I think.

    There is roughly 60% corelation between Asian markets and S&P500 also.

  5. Here are correlations between the SPY and the nine S&P sector ETF's using 5-minute bars for 1, 3 and 5 days.

    Ticke 1day 3day 5day
    XLK 0.9829 0.9823 0.9736
    XLI 0.9821 0.9811 0.9358
    XLY 0.9748 0.862 0.9172
    XLP 0.9688 0.5208 0.6053
    XLV 0.9448 0.955 0.4322
    XLE 0.9431 0.4868 0.4359
    XLB 0.9281 0.9338 0.951
    XLU 0.903 -0.4816 -0.0494
    XLF 0.8408 0.946 0.9504

    Doesn't look so useful on only one day's data, but we start to see separation on 3- and 5-day's worth of data. So tech (XLK) has the highest correlation in this period.

    Let's look at 30 largest holdings in the XLK ETF correlated to the SPY. Fourteen of the 30 stocks have a correlation above .80 over 5 days on the 5-minute bars, though some of those have negative correlation over one day.

    Ticker 1day 3day 5day
    ACN 0.9302 0.9688 0.9333
    GOOG 0.7398 0.8877 0.9256
    ORCL 0.8957 0.917 0.9242
    V 0.814 0.9057 0.9096
    EMC 0.6982 0.9131 0.9071
    INTU -0.4818 0.8688 0.902
    MA 0.771 0.893 0.8764
    TXN 0.8928 0.9205 0.8675
    INTC 0.894 0.9281 0.861
    CSCO 0.8096 0.913 0.8473
    MSFT -0.3076 0.8504 0.8421
    ADP 0.9653 0.8356 0.8419
    MSI 0.601 0.865 0.8362
    T 0.8457 0.8317 0.8235
    YHOO -0.629 0.7454 0.814
    ADBE 0.7368 0.9113 0.8062

    Also, here the correlations between the 30 largest holdings of XLK and the XLK. Only 11 of the 30 stocks had a 5-day correlation above .80.

    Ticker 1day 3day 5day
    INTU -0.453 0.8935 0.8972
    GOOG 0.7758 0.8861 0.887
    CSCO 0.8339 0.9449 0.8832
    V 0.8147 0.901 0.8744
    ACN 0.9305 0.949 0.8728
    ORCL 0.9174 0.8849 0.8622
    EMC 0.6069 0.9401 0.8574
    ADP 0.9746 0.8343 0.8541
    INTC 0.8896 0.93 0.8536
    TXN 0.8952 0.9299 0.8485
    MA 0.7608 0.8939 0.8125
  6. When estimating pairwise ETF correlations using 5 minute bars you should correct for Epp's Effect and microstructure noise, otherwise your estimates will be severely biased. The corrections developed by Zhang et alia in papers between 2005 and 2011 are as good as any. The RTAQ package in R implements this.

    Also, I hope you are adequately compensating for the overnight discontinuities in your 3 and 5 day estimates.