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How to Conduct Correlation Analysis in the Stock Market

By Dave

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Correlation Analysis in the Stock Market

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Correlation analysis is a way to measure the degree to which two stocks tend to move in the same direction at the same time. It’s an important analysis for investors who want to build a diversified portfolio that can withstand market shock and for traders who want to spot opportunities or hedge against risk.

In this guide, we’ll explain what correlation means in the stock market, why it matters, and how to analyze the correlation between stocks.

What is Correlation in the Stock Market?

Correlation is a quantitative measurement that describes whether two stocks move in the same direction at the same time.

If two stocks both experience a 10% gain over the same 30-day period, they would be considered highly correlated over that period. If one stock gains 10% in a steady climb and the other oscillates between +2% and -2%, those two stocks would be considered uncorrelated.

While it’s sometimes easy to see on a price chart that two stocks tend to move together, eyeballing price movements is imprecise at best and inaccurate at worst. Correlation analysis offers a way to quantify the degree to which two stocks’ movements are related.

The most common measurement of correlation is the Pearson coefficient, which ranges from +1.0 to -1.0.

  • A +1.0 coefficient indicates that two stocks are perfectly correlated—they always move exactly the same amount up or down at the same time.
  • A -1.0 coefficient indicates that two stocks are perfectly inversely correlated—for every 1% one stock gains in a given timeframe, the other stock will lose 1%.
  • A 0.0 coefficient indicates that two stocks are completely uncorrelated.

Note that a positive correlation doesn’t necessarily mean that prices are going up. Two stocks can also have a positive correlation if they both experience falling prices at the same time.

Types of Correlation in the Stock Market

While many traders and investors use correlation analysis to measure the relationship between two stocks, this type of analysis can be used to uncover relationships between any two variables. For example, you can measure the correlation between a single stock and the S&P 500. You can also measure correlation between a stock and commodity—for example, between an oil company stock and the price of oil. Or between a stock and an indicator—for example, between a ‘safe-haven’ stock and the VIX.

Correlation and Causation

An important thing to remember when discussing correlation is that correlation does not imply causation. Knowing that two stocks are correlated doesn’t tell you anything about why that correlation exists or whether it will continue.

Two stocks might be correlated because they’re affected by the same market trends or macroeconomic events. Or they might be correlated because the same large investor owns shares of both companies. Further analysis is needed to determine why a correlation exists and whether it will persist into the future.

Why is Stock Correlation Analysis Important?

Analyzing correlation in the stock market is important for both investors and traders. Here are some of the main reasons to use correlation analysis.

Portfolio Diversification

Investors commonly seek to build a diversified portfolio to manage the risk of investing. For most investors, the term “diversification” encapsulates investing in stocks that have low correlation (positive or negative) to one another.

If stocks in a portfolio are highly correlated, then investors could see their entire portfolio sink at the same time. On the other hand, if a portfolio contains stocks with low correlation to one another, then it’s likely that at any given time some stocks will gain value even if others are losing value.

Finding Trading Opportunities

Traders can use correlation analysis to find stocks (or combinations of stocks and indicators) that are highly correlated or inversely correlated. If two stocks are highly correlated and a trader sees one of them rising, they might expect that the other stock will soon rise as well and open a long position.

However, traders can’t use correlation blindly. It’s important to identify why a correlation exists in order to predict whether that correlation will hold true during the current movement.

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Hedging Against Risk

Traders and investors can also use correlation analysis to hedge against market risk. Say a trader has a large long position on a crypto mining stock, the price of which is highly correlated with the price of Bitcoin. Knowing this correlation exists, the trader could also purchase put options on Bitcoin to hedge their position in case the price of Bitcoin—and likely their crypto mining stock—falls.

How to Calculate Correlation Between Stocks

It’s possible to calculate the Pearson coefficient for two stocks by hand. However, this is time-consuming since you need to compare the price change for each stock over dozens or hundreds of time intervals. Most investors and traders rely on tools to calculate correlation automatically.

There are several free online tools that allow you to enter the tickers you want to analyze for correlation and choose your time interval:

Investors who want help building a diversified portfolio may want to consider a paid tool like Morningstar Premium. This not only offers correlation analysis for stocks in your portfolio, but also helps you achieve diversification by helping you visualize the overlap between the individual stocks you own and the stocks you own in ETFs and mutual funds.

When analyzing multiple stocks, correlation coefficients are often shown in a matrix. This lets you quickly view the correlation between many different pairs of stocks at once instead of calculating correlations one by one.

Using Correlation Analysis to Create a Diversified Portfolio

To give an example of correlation analysis in practice, we’ll look at building a small portfolio of stocks. To start, we’ll include 7 stocks from several different sectors:

  • AAPL
  • TSLA
  • GE
  • BOA
  • XOM
  • FDX
  • TGT

These stocks are relatively uncorrelated, but TSLA and XOM have a correlation coefficient of 0.64. XOM also has a correlation coefficient of 0.54 with FDX. So, we’ll replace XOM with another stock from a different industry to achieve greater diversification.

Example Portfolio Correlation Analysis

Keep in mind that correlation analysis is just one part of building a diversified portfolio. Investors also need to think about performance, value, growth potential, and more. Correlation analysis should be used to double-check a portfolio to ensure it meets an investor’s diversification needs, but it shouldn’t be the driving factor when choosing what stocks to buy.

Conclusion: Correlation Analysis in the Stock Market

Correlation analysis is a way to measure how closely tied the price movements of two stocks are. Investors may want to avoid high correlation when building a diversified portfolio, while traders may seek out correlation to spot trading opportunities. Traders and investors alike can also use correlation analysis to identify opportunities for hedging market risk. Keep in mind that it’s important to understand the reasons why two stocks are correlated when making trading and investing decisions.

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Dave has been a part-time day trader and swing trader since 2011 when he first became obsessed with the markets. He focuses primarily on technical setups and will hold positions anywhere from a few minutes to a few days. Over his trading career, Dave has tried numerous day trading products, brokers, services, and courses. He continues to test and review new day trading services to this day.

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