Correlation - you may be using it wrong

3 thg 8, 2020

We are seeing a lot of undocumented info about how to trade based on correlation coefficient and we made an article with proof of why that approach is wrong.

Here is a the last part of the article.
The full article is here:
https://prop-quant.com/2020/08/03/correlation-you-may-be-using-it-wrong/

Why most people trade it WRONG?
Because they are not putting enough time and effort to deeply understand it
Because they are google-ing it and trusts every piece of info, regardless of its source.
Because they believe in quick, easy and passive profits

Key takeaways about the Pearson correlation

A strong correlation (close to 1 or -1) for a certain period of time does NOT mean that in the future if the correlation coefficient drops, you can make profits by selling the higher and buying the lower, regardless of the time axis type.

*Two assets can be strongly correlated but to infinitely move away from each other. In the chart below you can see two series (you can think of them as stock prices) that are diverging and never converging aaaand...surprise (again): the correlation coefficient is 0.99. This is not real data, it is just to prove how the correlation coefficient works.


*You need to combine statistical analysis with other types of analysis (other technical indicators, fundamentals, news)
If you are looking for trading based on correlation, you should definitely think about the actual markets you want to trade on and calculate all your costs (for ex: trading OTC indexes will charge you every night and that might eat-up a good chunk of your potential profits)

To sum up, the Pearson correlation coefficient is a great tool but you need to deeply understand it in order to create a solid trading system around it.

In the end, one tip for you: if you had false expectations regarding the way to trade on correlation you might want to read about cointegration.

Happy trading!