What is correlation?
In the finance and investment industries, correlation is a statistic that measures the degree to which two securities move in relation to each other. Correlation is computed into what is known as the correlation coefficient, which has a value that must fall between -1 and 1.
Correlations are commonly used in advanced portfolio management, as they allow the manager to monitor which assets within the portfolio are returning more profits and which are less valuable.
How does correlation work?
When the correlation coefficient equals 1, we have a perfect positive. This means that as one security moves, either up or down, the other security moves exactly in the same direction. A perfect negative correlation means that two assets move in opposite directions, while a zero correlation implies no relationship at all.
For example, large-cap mutual funds generally have a high positive correlation to the Standard and Poor’s (S&P) 500 Index, very close to 1. Small-cap stocks have a positive correlation to that same index also, but it is not as high, generally around 0.8.
On the other hand, put option prices and underlying stock prices tend to have a negative correlation. As the stock price increases, the put option prices go down. This is a direct and high-magnitude negative correlation.
Category: Financial Glossary