Reader Questions Answered

Correlation analysis for trading position diversification

I got the following inquiry from the ever-curious Trader Rod.

A few questions concerning correlation between two instruments for the purpose of diversification:

1. When calculating the correlation coefficient, given my time frame is daily, should I focus on daily closing prices or daily returns?

2. If the answer to previous question is to focus on returns, and the average holding period for a position is one week, should I calculate the coefficient using series of weekly returns?

3. What is a good threshold for diversification, i.e. at which point do I decide the two instruments are too highly correlated, e.g. anything below 0.7 is acceptable ?

Correlations have been gaining in focus of late, no doubt in large part due to the very obvious and public linkages between the dollar and stocks. It’s hardly a new thing, though. It’s been used in the type of work Rod is describing here for decades. Modern Portfolio Theory, for example, is heavily involved with correlation analysis. In other words, this isn’t a new field of analysis, so if it’s something you have a mind to explore there’s plenty of reading you can find on the subject. Make sure you do take a half approach, though. Using correlations without understanding what they are, what they mean, and how they can change can be extremely dangerous. Just ask the blown up banks and hedge funds who didn’t make it through the credit crisis.

As for Rod’s specific questions:

1) You should always use returns. They are how you can compare two instruments in a standardized fashion. Otherwise, differences in the prices of the securities can create comparison problems.

2) A holding period of only a week makes correlation application challenging. They tend not to be that stable in the short time frames. At best I’d say look at a rolling 5-week correlation and use it as a rough guideline. But realize that it’s only rough. There’s likely to be considerable deviation.

3) To achieve true diversification between two securities you need to have a near zero or negative correlation.

Trading Tips

Individual Stocks are Bad

There’s a post on the Moolanomy site about the subject of investing in individual stocks. Which makes a couple of statements worth addressing.

The first is:

…no one should own individual stocks

You might think I’d argue against this particular statement, but I won’t. Speaking strictly from an investment point of view (as opposed to trading), holding individual stocks is probably not something most people want to do. It takes a sizeable portfolio to be able to create a well diversified portfolio (like 30), which is difficult for many individuals to reach. That means ETFs and mutual funds tend to be the better choice.

Here’s the other bit I wanted to comment on:

One of their studies found that the stocks individuals buy underperform after they buy them and outperform after they sell them. This is actually a commonsense outcome. The reason is relatively simple. Let me explain. For every buyer there must be a seller. Since the vast majority (about 80%) of the trading is done by institutional investors (who almost certainly know more than the individual investor) that it is likely that when an individual buys a stocks (because he thinks it will outperform the market) the likely seller is an institution (who thinks it will underperform or they would continue to hold it). And the institutional investor is more likely to be right.

The institutional investor is more likely to be right? Hmmm…. I’m not entirely sure of that, but there are a couple of links in the post to research which are said to support these statements. You may want to check them out. I haven’t had the time to do so as yet, but do wonder whether the academics of it are overly narrow as is often the case in situations like this.

Again, this is investing talk, not trading talk. There’s no suggestion here (especially from me) that trading individual stocks is a bad idea.

Trading Tips

Defending Options Trading Against Blogger Attack

A fellow trading blogger wrote some things which really irked me. I’m not going to say who it was or link to the post as I normally do because basically all the guy does is plug his trading system in every post. He’s been on a multi-post rant about how people shouldn’t trade options or futures, or any other leveraged instrument for that matter. Two of the quotes this individual made in one of his recent posts in particular caught my eye.

With options trading, you need really good money management skills and many positions for diversification purposes.

If we took “options” out of the above sentence the first part of it would be fine. Good money management is a requirement of trading in ANY market. As for the requirements for diversification, to the extent that someone is going to diversify, it applies equally to any type of equity trading.

By the way, while investors who plan on long holding periods would do well to diversify their holdings, the same doesn’t necessarily hold for traders. In fact, the latter are better off keeping things concentrated so they can properly track their positions.

Since both options and ultra ETFs are about leverage, it makes more sense to go into ultra ETFs because they’re generally much safer than options and offer similar outsized returns.

I can’t help but wonder how the blogger is defining safety. If it has anything at all to do with the potential to take a loss larger than expected, then the ETFs are riskier than owning options, not safer. It’s a very simple thing. If you buy an option your risk is clearly defined. You can’t lose any more than what you paid. In the case of an ETF, however, you can easily lose more than you intended to risk because even if you use a stop there’s no guarantee of a fill at your exit price.

Now, if the blogger is equating risk to the odds of taking a loss, then that’s a different conversation. I’m still not going along with his take on things, however, because as I’ve previously noted in other posts, win % (or loss %) is not the sole determinant of performance.

I’ve said it before. It’s not leverage that creates risk. It’s how you trade. I personally prefer options for my equity trading because I can strictly define my risk and better manage positions on a running basis, plus they require less capital. That said, however, options suit the way I play the stock market. They will not do so for everyone.