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Wednesday, April 11, 2012 Issue 37


Understanding and Using Correlation Analysis

Frederic Palmliden, CMT
Senior Quantitative Analyst
TSLabs@TradeStation.com
Features Studies/Files Included:
Focus: Technical Workspaces
Markets: Equities, Futures, Forex Indicators
Time Perspective: Short-term,
Intermediate-term, Long-term

Summary
Correlation analysis is about observing the interaction of
various securities and markets. Since these relationships
are dynamic, it is useful to measure them historically and to
monitor them in real time. For example, this analysis may be
useful in revealing which securities in a portfolio provide
diversification and which may be duplicating unwanted risk.
Here, two custom indicators are used to highlight inter-
market relationships.

Figure 1 Futures Continuous Contracts (@ES and @CL) with the TSLabs: CoeffR Indicator


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Background
Pearsons correlation coefficient between two variables is
defined as the covariance of the two variables divided by the
product of their standard deviations:

=
(, )


In the world of finance, correlation is a statistical measure
of how two securities move in relation to each other.
Correlation is computed into what is known as the
correlation coefficient, which ranges between -1 and +1.
Perfect positive correlation (a correlation coefficient of +1)
implies that as one security moves, either up or down, the
other security will move in lockstep, in the same direction.
Alternatively, perfect negative correlation means that if one
security moves in either direction the security that is
perfectly negatively correlated will move in the opposite
direction. If the correlation is 0, the movements of the
securities are said to have no correlation; they are
completely random. In real life, perfectly correlated
securities are rare; rather, you will find securities with some
degree of correlation (Investopedia 2012).
TSLabs: CoeffR Indicator Description
The first custom indicator presented in this paper is the
TSLabs: CoeffR indicator, which graphically depicts
Pearsons product moment correlation coefficient R, also
known as the coefficient R. Due to price variability among
securities, it soon becomes apparent that the line tracking
the coefficient R is quite volatile even when the length of the
look-back period is large for example, 120 days, or roughly
six months of data. Therefore, it might be useful to use
percentage moves instead of price moves. Using daily
percentage moves instead of daily prices as inputs for the
coefficient R function smoothes out the coefficient R line
dramatically (see the blue histogram versus cyan line in
Figure 1). Both methods have advantages and
disadvantages that will be discussed shortly. The different
inputs for the TSL CoefficientR indicator are described in
Table 1.
Table 1: CoeffR Inputs
Input Name
Input
Value
Input Description
CorrLength_Price 120
Look-back length for the coefficient R
based on price moves
CorrLength_Perc 120
Look-back length for the coefficient R
based on percentage moves, e.g., daily
percentage moves
CoeffR_Price TRUE
Boolean value (True/False) to show the
coefficient R based on price moves
CoeffR_Perc TRUE
Boolean value (True/False) to show the
coefficient R based on percentage
moves
CoeffR_PriceColor Cyan
Color for the coefficient Rbased on
price moves
CoeffR_PercColor Blue
Color for the coefficient Rbased on
percentage moves
RefLinesColor Black
Color for the reference lines (+1, -1, and
0 lines)

CoeffR Analysis
The main advantage of using the price moves is that the
CoeffR line will usually reflect a change in correlation faster
than the coefficient R based on percentage moves,
assuming the same look-back length. An example is
provided below in Figure 2, where the euro currency and
crude oil became highly positively correlated for many
months in the beginning of 2007. Notice how the
CoeffR_Price line (cyan line) increased sharply towards +1,
while the CoeffR_Perc line (blue histogram) reflected an
uncorrelated reading during the same period before finally
increasing around the end of 2007. Therefore, depending on
the application, it may be adequate to have a shorter look-
back length for the CoeffR_Perc versus that for the
CoeffR_Price, to identify correlation changes quicker.
While the point above may be a disadvantage for the
CoeffR_Perc for some applications, it may be an advantage
for other applications. For instance, when researching
longer-term correlations among securities within a portfolio,
it might be useful to use the correlation coefficient based on
percentage moves, since the concern may not be short-lived
correlation shifts, but rather sustainable relationships.
Figure 2 Futures Continuous Contracts (@ES and @CL) withthe TSLabs: CoeffR Indicator (2006-2008)

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The ability to view the correlation between two securities
across a large time frame is a definite benefit of the CoeffR
indicator. However, when numerous securities are
considered, a matrix form is preferred, especially when
comparing current correlation coefficient values.
TSLabs: Correlation Matrix Indicator
Description
The second custom indicator presented in this paper is the
TSLabs: Correlation Matrix indicator for RadarScreen,
which displays the coefficient R values for all of the
two-security combinations from the first column of symbols
in a RadarScreen window (see Figure 3). Notice that the
same securities are listed in the first column and in the first
row. Notice also that the securities are listed in the same
order. Thus, the Matrix includes a diagonal with perfect
positive correlation values (R = 1), since those cells reflect
the correlation of each security against itself. The
Correlation Matrix in its current form is designed to include a
total of 10 different symbols. If applicable, a benchmark for
the different securities, such as SPY for stocks or sectors,
may be used in the last row and in the last column for
reference purposes.
The symbols used may be changed by changing the
symbols in the first RadarScreen column (Symbol column)
and changing the input symbols on the indicators Format
Indicator - Inputs tab. However, the plot names containing
the symbols are embedded in the EasyLanguage (line 228
through 237) and will not change automatically. In addition,
decreasing or increasing the number of symbols used in the
indicator requires additional work in EasyLanguage.
The date for the different correlation coefficient values can
be specified as an input and is displayed in the last column
of the indicator in the RadarScreen window for reference
purposes. One can monitor current values by typing Today
as the input.
The coefficient R for each pair of securities may be based
on price or percentage moves, as in the CoeffR indicator for
charting; however, in this case, only one approach may be
used at a time. The choice of method is determined by the
CoeffR_Price_Or_Perc input (1 for correlation values based
on price moves, 2 for correlation values based on
percentage moves).
When using a large look-back length for the coefficient R
values, it may be necessary to adjust the amount of data
loaded into the RadarScreen window. To adjust the amount
of data, specify the number of bars to load on the General
tab of the Format Indicator dialog. The field is titled, Load
additional data for accumulative calculations. Notice that
the field needs to be checked in order to edit the additional
bars to load.
The different inputs for the TSL CoefficientR indicator are
described in Table 2.
Table 2: Correlation Matrix Inputs
Input Name Input Value Input Description
iSymbol1 XLY
First RadarScreen column
symbol
iSymbol2 XLP
Second RadarScreen column
symbol
iSymbol3 XLE
Third RadarScreen column
symbol
iSymbol4 XLF
Fourth RadarScreen column
symbol
iSymbol5 XLV
Fifth RadarScreen column
symbol
iSymbol6 XLI
Sixth RadarScreen column
symbol
iSymbol7 XLB
Seventh RadarScreen column
symbol
iSymbol8 XLK
Eighth RadarScreen column
symbol
iSymbol9 XLU
Ninth RadarScreen column
symbol
iSymbol10 SPY
Tenth RadarScreen column
symbol (benchmark)
TargetDate Today
Correlation as of date in
"MM/DD/YYYY" format, e.g.,
"05/06/2010" = May 6, 2010, or
"Today" = current date
CorrLength_Price 120
Look-back length for the
coefficient R based on price
moves
CorrLength_Perc 120
Look-back length for the
coefficient R based on
percentage moves, e.g., daily
percentage moves
CoeffR_Price_Or_Perc 1
1 = coefficient R based on price
moves
2 = coefficient R based on
percentage moves
PerfCorrFont White
Font color for perfectly
correlated securities (R= 1)
PerfCorrBG Blue
Background color for perfectly
correlated securities (R= 1)
HighCorrColor Dark Magenta
Color for highly positively
correlated securities (R> -0.75)
LowCorrColor Dark Magenta
Color for highly negatively
correlated securities (R< -0.75)

Correlation Matrix Analysis
The main advantage of using the Correlation Matrix is the
ability to view coefficient R values for a large number of
symbols in the same window as of a specified date. In
Figure 3, the coefficient R values are calculated as of May 6,
2010, which was the date of the 2010 Flash Crash.
Changing the specified date in the inputs tab around this
particular day reveals dramatic shifts in correlation. For
instance, Financials (XLF) and Utilities (XLU) had a
coefficient R value of 0.10 on May 4, 2010 (price-based
coefficient R and look-back length of 21), and the value
jumped to 0.91 by May 20, 2010, which is to say that the
pair went from being uncorrelated to highly correlated very
rapidly. Other sectors had similar shifts in correlation during
the same time period (see Figure 4).

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Figure 3 S&P Sector ETFs with the TSLabs: Correlation Matrix Indicator (as of May 6, 2010)

Figure 4 S&P Sector ETFs CoefficientR Values Around the 2010Flash Crash
The previous example highlights the fact that correlations
can change rather quickly under special circumstances.
During normal market conditions, however, correlation
analysis usually reveals which securities provide
diversification, or duplicate risk, on a consistent basis. For
instance, an equity investor may be surprised to see how
correlated certain equities are in his or her portfolio. In such
a case, a low level of diversification is achieved within the
equity allocation and the investor may want to rethink
current holdings. Adding uncorrelated equities could
generate risk-reducing benefits. The idea here is that the
positive performance of some positions will counter the
negative performance of other positions. Additionally, pairs
of securities that are negatively correlated may further
reduce risk. Pairs trading can take many forms and this
would be just one possible approach. Also keep in mind
that, in practice, negatively correlated equities are hard to
find and other asset classes may need to be considered,
which brings us to the next point.
The Correlation Matrix can include securities of any type.
The process to update the securities is outlined on page 3
above. The Correlation Matrix in Figure 5 includes the main
forex pairs as of March 15, 2012. In this particular case, the
CoeffR_Price_Or_Perc input is set to 2 for coefficient R
values based on percentage moves and the look-back
length is set to 120. By using these settings, notice that the
EURGBP is uncorrelated to the GBPUSD, while the
EURUSD has a nearly perfect positive correlation with the
USDCHF. Changing to coefficient R values based on price
moves and/or changing the look-back length would affect all
values displayed by the Correlation Matrix indicator. A
shorter look-back length would, for example, capture the
more recent correlation, while de-emphasizing the historical
relationship.

Figure 4 Forex Pairs with the TSLabs: Correlation Matrix Indicator (as of March 15, 2012)
Conclusion
Correlations between securities are often mistakenly
assumed to hold during different market conditions. Certain
securities can at times be highly positively or negatively
correlated for only a season. Some of these relationships
tend to be cyclical for some securities, such as @CL versus
EURUSD. Other relationships tend to persist over time, such
as the Dollar index versus the 3-Month UST/3-Month Euro
implied differential spread. Once analysis has been
performed for a particular relationship, different predictions
may be made, with probabilities, as to how long a
relationship may be expected to hold or how long
divergence is expected to continue before positive or
negative correlation resumes. These findings can then serve
as grounds for mean-reversion as well as trend-following
strategies.

Works Cited
Investopedia. Correlation. March 21, 2012. http://www.investopedia.com/dictionary/TermDefinitionPrintable.aspx?url=/terms/c/correlation.asp
(accessed March 21, 2012).

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