Correlation Definition

Correlation measures how well two things move together.    For example, if gold miner stocks usually rise as the price of gold rises, we say they are correlated.    If bonds rise as stocks fall, we say they are negatively correlated. 

Using statistics, we can measure the degree of correlation.    The scale is a range between

• -1 (moving exactly opposite)
• 0 (completely independent) 
• 1 (moving in lock-step in the same directions)

Extra Insight:

Correlation doesn’t say anything about cause and effect.   Just because two things are highly correlated, it doesn’t mean that one causes the other, or that they will be as highly correlated in the future.  If two things are not correlated, that says one does not cause the other.

Its important to stock trading and backtesting to find two things that move together — that can be a trading opportunity!   A high correlation between trading signal and profit is exactly what we want. 

However, its possible that the correlation is due to chance which won’t make a good trading rule at all. 

To find a trading strategy which is likely to really work requires disciplined backtesting and statistical analysis.

Tags: backtesting, statistics