What is Correlation Trading?

Correlation trading is a type of investment strategy that requires the investor to evaluate the performance of a given security, identify a similar security that shows promise of following the same general trend, and take steps to trade that security. The degree of similarity may vary, although the factors that influence the movement of each asset are often influenced by the same base set of factors. An example of correlation trading may involve considering the movement of gold in the marketplace and then choosing to buy silver since that investment is likely to trade in a similar manner.

The general concept of correlation trading can be used with just about any type of investments. With currency trading, the process will involve identifying two specific currencies that demonstrate the same pattern, and arrange purchases and sales to take advantage of that pattern. In like manner, it is possible to trade stock options using correlation trading, often identifying a stock that is not as well known and locking those shares in before other investors begin to notice the similar movement. Even bond investments can be considered in pairs, making it possible to locate and lock in bond issues that produce returns very similar to bonds issued by entities that are more widely known in the investment community.

One of the benefits of correlation trading is that it encourages some degree of diversification within an investment portfolio. Since many forms of modern portfolio theory include at least some suggestions that diversifying the portfolio in any economy is a good idea, finding common ground or correlation between two similar securities can be viewed as a means of diversifying holdings even within one particular segment of the portfolio. For example, this approach can be used to diversify the range of telecommunication stocks held by the investor, making it easier to offset losses incurred by some of those shares with gains accrued with others.

Since correlation trading requires the identification of two holdings that exhibit similar trade patterns, investors using this approach must understand industry trends as well as market trends. This makes it easier to qualify a given opportunity as being similar to the investment used as the standard for the comparison, and determine if the degree or similarity is sufficient to support the idea that the asset will perform in a parallel manner. Unless there is a strong similarity between the two investments, the trading strategy stands very little chance of producing the desired results.