Correlation Portfolio Diversification

A Macro-Economic Study of Correlation between Tradeable Assets

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It can be challenging to visualise the correlation between assets when you have a whole portfolio full of them. You can create a heatmap that shows all the assets in your portfolio and the correlation between them.

And in true Darwinex fashion, we’ve created a heatmap for 40 of the Darwinex platform assets. This heatmap gives us a high-level view of the correlation between this universe of tradeable assets at Darwinex.

It might look like some random NFT, but what this heatmap does is display the correlation between every asset in an easy to see manner. Using a heatmap in this way can help speed up asset selection when deciding on what to put in your portfolio.

Correlation is the enemy of Diversification.

It gives you a clear view of what combinations of assets are likely to provide good diversification benefit and which ones are likely to not. This extra clarity is essential because trading correlated assets can increase the risk on the portfolio.

What is Delta?

Delta is a mathematical term that simply means a change in value. In a previous post, we showed you how to calculate (r) and (R²), but we highlighted a flaw in this approach and showed you how to calculate (R²) using the Delta (the price change) instead, which is a much more robust way to calculate the correlation.

Using the heatmap, we can see the correlation between an FX major like GBPUSD and the FTSE index. Looking at the heatmap, we can quickly see that these have a correlation of 0.00036. This correlation would indicate that trading these two assets at the same time could provide us with diversification benefit.

Take a look at Martyn’s heap map. If you had to pick 2 FX pairs, a stock index and a commodity, what would you choose and why?

As always, answers on a postcard @darwinexchange

This post covers the correlation between assets. But there are three other techniques we’ve used previously. In the next episode, we take a look at the correlation between timeframes.

Brought to you by Darwinex: UK FCA Regulated Broker, Asset Manager & Trader Exchange where Traders can legally attract Investor Capital and charge Performance Fees.

Risk disclosure:
https://www.darwinex.com/legal/risk-disclaimer

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Content Disclaimer: The contents of this video (and all other videos by the presenter) are for educational purposes only, and are not to be construed as financial and/or investment advice.

Benefits of Portfolio Diversification

How to Measure Correlation Between Assets

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In the previous episode, we showed you two ways to measure correlation. These were; coefficient of correlation (r) and coefficient of determination (R²). These are two widely used techniques for measuring correlation.

However, they do have their limitations.

When the quote currency in two fx pairs is the same, there will always be a correlation. However, due to the fundamental differences in base currency, they will also display uncorrelated behaviours.

This gives us an incorrect view whereby the (R²) number indicated a high level of correlation but the outlying data points highlighted the uncorrelated nature too. Talk about confusing.

A small change can have a big effect.

Today we’re going to make a subtle change that can provide a more robust view of the correlation between assets.

Instead of using price, we’re going to use the price difference. As an example, if we subtract an assets close price from the previous days’ close price, we can see the price change. It is this change in price that we will use for our new calculation.

Already you should be able to see the benefit of using this way. It allows us to compare price movements between the two assets.

We’ve given you a few examples of how correlation differs between assets and a few examples of different ways to measure correlation.

You can take this one step further by creating a correlation matrix in Excel for an indefinite number of assets.

Try doing the above to measure correlation between all the assets you have in your portfolio and see how diversified your asset selection is.

Darwinex helps you measure correlation of Darwins.

Darwinex has already done the hard work for you on the Darwinex platform by calculating the correlation between Darwins.

Remember a Darwin is an asset that tracks the performance of a traders underlying trading account, in real-time. Darwinex then manages the risk of the Darwin independently from the trader to target a max VaR (95%) of 6.5%.

To view the correlation between Darwins go to the correlation tab. It will show the correlation between the asset you have selected and a range of other Darwins. To check a particular darwin enter its ticker into the search box under the table to see the correlation between them.

Brought to you by Darwinex: UK FCA Regulated Broker, Asset Manager & Trader Exchange where Traders can legally attract Investor Capital and charge Performance Fees.

Risk disclosure:
https://www.darwinex.com/legal/risk-disclaimer

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Content Disclaimer: The contents of this video (and all other videos by the presenter) are for educational purposes only, and are not to be construed as financial and/or investment advice.

Measure Correlation Portfolio Diversification Trading Strategy

Measuring Portfolio Diversification Correlation – A Common Mistake

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Take care to avoid common mistakes when Measuring Portfolio Diversification Correlation. It is especially important to not view the results with blinkers on and ignore important information that is right in front of us.

Ultimately we want to improve the robustness of our trading strategies and Measuring Portfolio Diversification Correlation is a beneficial way to do this. But it is possible to wrongly make assumptions ignoring data, often unintentionally.

The easiest way to illustrate this is in Excel. Remember in the previous video we promised you, you don’t need to have experience in coding.

Well, we keep our promises.

You’ll need to first import the data of the assets you want to compare. Next up, pick the two assets you want to measure the correlation of. Input your formulas into excel and let it figure out the rest.

Next, display your results in a nice visually easy manner and you’re almost done. A couple of clicks later and you have an easy to see chart and the (R²) number.

Using the (R²) instead of (r) removes the negative numbers and groups the positive and negative correlation together, as these both can have a negative impact.

Remember we said at the start, you need to avoid some mistakes when measuring portfolio diversification correlation.

If we pick two assets that have the same quote currency, the USD for instance, you would expect two XXXUSD pairs to be correlated but…

WARNING

They will not always be correlated due to differences in the base currency. This can give an unreliable (R²) figure. You can see on the chart in the video there are many outliers. Although we have a nice high (R²) score, you need to be careful.

If we now do the same for two stock index pairs, we can expect these to be correlated. Stock indexes tend to move together, which they are. So even though these two pairs give us similar results we can trust the stock index value more.

When systematically testing various aspects of your trading strategy you need to try to disprove your theories. Yes, disprove. Only by trying to disprove them will you find truly robust parameters and metrics to use.

Which of these 3 pairs do you think has the strongest correlation?

  1. AUDUSD & NZDUSD
  2. GBPUSD & AUDUSD
  3. AUDJPY & USDCAD

Answers on a postcard or just tag us on Twitter at @darwinexchange might be easier.

Brought to you by Darwinex: UK FCA Regulated Broker, Asset Manager & Trader Exchange where Traders can legally attract Investor Capital and charge Performance Fees.

Risk disclosure:
https://www.darwinex.com/legal/risk-disclaimer

—
Content Disclaimer: The contents of this video (and all other videos by the presenter) are for educational purposes only, and are not to be construed as financial and/or investment advice.

Benefits of Portfolio Diversification

Measuring Correlation to inform your Portfolio Diversification Strategy

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Measuring correlation is as important as portfolio diversification itself. We can’t diversify our portfolio without first measuring correlation between the assets and strategies in our portfolio.

In fact, not measuring correlation will potentially lead to the risk we are exposed to increasing. By having exposure in two correlated positions, we are effectively doubling our exposure to this risk.

So how do we measure correlation?

The method for measuring correlation will differ depending on what technique we are using to diversify our portfolio. Remember the four techniques we covered previously in this series. These were:

  • Across asset classes
  • Within the same asset class
  • Across different timeframes
  • Across trading strategies

Throughout this mini-series, we’re going to look at different methods of measuring correlation.

To kick things off; we are going to start with the Coefficient of correlation (r) or Pearson’s r, as it’s also known. Karl Pearson developed the idea. He also founded the world’s first university statistics department at the University College, London.

Pearson’s r measures the strength of a linear relationship between two variables. It does this by creating a line of best fit between variables and measures the distance of each variable to the line of best fit.

This results in a range of results between -1 and +1. -1 would be a negative correlation, 0 would be no correlation and you guessed it +1 would be a positive correlation.

What do we mean by positive and negative correlation?

An example of a positive correlation would be two separate trades in the same direction, on the same asset. When the asset price rises; both the trades will gain, due to the positive correlation between the two trades.

A negative correlation would be simply the opposite. Two separate trades in different directions on the same asset. When the asset price rises one trade will gain whilst the other loses and vice versa if the asset price falls.

Positive and negative correlation can both negatively affect our portfolio.

So why measure them individually?

We don’t have to. There is another way to measure correlation. The coefficient of determination (R²).

This takes Pearson’s r and squares it. Doing so removes the negative part of the range leaving a range of 0 to 1. 0 would equal uncorrelated and 1 would equal either positively or negatively correlated. As both positive and negative correlation will negatively impact the portfolio this way would seem to make sense.

Brought to you by Darwinex: UK FCA Regulated Broker, Asset Manager & Trader Exchange where Traders can legally attract Investor Capital and charge Performance Fees.

Risk disclosure:
https://www.darwinex.com/legal/risk-disclaimer

—
Content Disclaimer: The contents of this video (and all other videos by the presenter) are for educational purposes only, and are not to be construed as financial and/or investment advice.

Balance Risk Diversified Portfolio

How to Balance Risk across your Diversified Portfolio

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Why do we want a Diversified Portfolio when it reduces our absolute returns?

If we think back to our previous video, remember that we’re trying to increase our risk-reward ratio, not absolute returns. We want to balance the risk of our portfolio.

We believe that risking 1 to get 1 is better than risking 10 to get 5.

Now, this objective is clear, let’s take a look at how we’re going to balance risk across our diversified portfolio.

Last time we covered 4 techniques to implement portfolio diversification into our portfolio.

These were across:

  • Asset Classes
  • Uncorrelated assets within an Asset Class
  • Timeframes
  • Trading Strategies

But how do we assign capital or risk to each of these?

We’ve identified 4 ways to balance risk across a diversified portfolio and we’ll go over each of these now. 

  1. Fixed position size per trade. This is by far the easiest to implement but by no means an effective way of weighting your portfolio strategies. This method affects our risk by: 
    • The size of the stop-loss.
    • The volatility of the underlying asset
    • It will change based on the account equity
  2. Equivalent position size per trade. This is similar to the 1st way, albeit a little more dynamic. All the above will apply with the added consequence of varied position sizes depending on open positions. 
  3. Equivalent risk per trade. Probably the most well-known and widely used. Here we balance the risk for each trade. We adjust the position size factoring in the stop loss size. This means that each trade will have the same risk expressed as a percentage of account equity, one thing this approach doesn’t take into account is the correlation of each position. So 2 positions in correlated assets will effectively increase the risk to the portfolio.
  4. Reward/risk ratio portfolio optimization. This takes into account the following 3 factors: 
    • The relative correlation between each diversification technique.
    • Alpha of each portfolio component.
    • The volatility of each underlying component.

This way is the most complicated but as you can see, provides us with the most comprehensive approach to a Diversified Portfolio. As it’s the most complicated we’re only able to scratch the surface in this post and will need to cover this in more depth in future episodes. 

As always Darwinex has you covered when providing you tools and metrics to help keep track of the inner workings of your portfolio.

We’re going to look at 2 Investible Attributes that can provide valuable insight into the risk exposure of your portfolio.

The first is the Risk Stability (Rs) investible attribute.

This measures the consistency of the risk. A nice flat line means the risk is fairly predictable over time and can be considered a positive.

Large peaks and troughs mean the behaviour of the trading strategy may be unstable and can lead to unpredictable levels of risk. 

Next up is the Risk Adjustment (Ra) investible attribute.

The Darwinex platform is unique in that, Darwinex manages the risk of investments in DARWIN assets independently of providers, ensuring that they carry a monthly maximum target VaR (95%) of 6.5%.

This shows up on the Ra investible attribute as outliers on the chart and is coloured differently. 

Brought to you by Darwinex: UK FCA Regulated Broker, Asset Manager & Trader Exchange where Traders can legally attract Investor Capital and charge Performance Fees.

Risk disclosure:
https://www.darwinex.com/legal/risk-disclaimer

—
Content Disclaimer: The contents of this video (and all other videos by the presenter) are for educational purposes only, and are not to be construed as financial and/or investment advice.

Darwinex Trading Schedule Easter 2018

Trading Schedule for the 2021 Easter Holiday Period

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Please note the amended Darwinex Trading Schedule for the 2021 Easter Holiday Period is already available in the calendar of Amended Darwinex Trading Hours.

Please note during Easter Holidays, swaps will be charged in a different way than on normal weeks. There may be days with swap x6 charges and days without any swap charges at all. The amount of the swap will be similar to that of normal weeks, the only thing that changes is the way it’s charged. The swap rates that appear on our site generally get updated around 19:00 BST and may suffer only minor changes afterwards.

The DARWIN Exchange will remain open even if the underlying assets’ market is closed. Should you want to know the standard procedure when you buy/sell a DARWIN whose underlying asset market is closed, we recommend you to read the following Knowledge Base article: Can I buy and sell DARWINs whenever I want?

Do not hesitate to contact us at info@darwinex.com for support.

Happy Easter!