Correlation Co-efficient (CC) is a statistical tool that is used to measure the relationship between two datasets. When talking about trading, the datasets would be stocks or any other financial instruments.
The value of correlation varies from +1 to -1. The closer the correlation is to +1, the tougher the relationship is. A value of 0, though, means there is no correlation.
Correlation is a term that is generally used with regression analysis. There are two variable involved in correlation analysis: ‘Dependent Variable’ and ‘Independent Variable’. The independent variable is an indicator – one that determines where the trend will go. Dependent variable, on the other hand, changes as a result of the independent variable’s effect on it.
Importance of Correlation Analysis
Correlation analysis in trading can prove to be a great guide. It can help you in better, more enhanced decision-making.
Some of the advantages of correlation analysis in trading include;
- Identifying relationships between two variables,
- Determining where their directions would be,
- Helping execute trades depending on the data presented.
Pairs traders choose instruments whose prices generally move together. This gives them greater control. Some of these trading pairs include;
- Coca-Cola and Pepsi,
- Dell and Hewlett-Packard,
- Exxon and Chevron,
- Duke Energy and NextEra Energy.
Correlation Analysis in MetaStock
MetaStock offers incredible correlation analysis tools. Simply put, the software provides insights about how the variables or instruments move together. Generally, a value above +0.7 indicates a stronger correlation; whereas, a value below -0.7 indicates negative correlation.
Many stock investors turn to MetaStock to enhance their portfolio. Investors look for pairs that are negatively correlated, like Gold and US Dollar. This trading in pairs is also called convergence trading. As a best practice, the investor assesses the spread for a period of time as the correlation keeps getting negative. Investors will put their money in positions where the two stocks are converging and are turning back to positive correlation values.
As an example, correlation analysis in MetaStock could be used to determine a relationship between two securities. It will tell you whether one security’s price is positively in line with another security’s price. It will also help you determine changes for brief periods of time, like couple of months.
This helps you make better trading decisions. It enhances the likelihood that you will be making profits. MetaStock terms its correlation analysis tool an ‘Unsung Indicator’.
We at MetaStock Australia have more than 20 years of experience with MetaStock. From providing assistance with downloads to helping with trading decisions, our team helps you in every step of the way. Contact our team to learn more.