What is the Correlation of your Trading Strategy and the Market?

Market Correlation is a topic that’s been covered extensively before this post. The correlation between assets within an asset class or even the correlation between trading strategies themselves. Correlation can take many forms.

Darwinex created an Investible Attribute called, you guessed it, Market Correlation. This Investible Attribute doesn’t measure the correlation between strategies or assets.

Instead, it measures the correlation of the Strategy and the underlying market.

Intrigued? Thought you might be.

Suppose the performance of your trading strategy starts to decay. In that case, the higher-level performance metrics mentioned in the previous posts do little to ascertain the route cause for the change in performance.

SQN, D-Score, Sharpe ratio can all tell you how well a strategy is doing. However, what they can’t do is tell you what part of the Strategy is causing a decrease in performance.

The SQN won’t tell you if your entry timing is less effective or if your position sizing is too high, causing increased drawdown. To do this, you need metrics that focus on the key aspects of a trading strategy.

That’s where Darwinexs’ Investible Attributes come in.

Because Darwinex realised that being able to rank various factors of a trading strategy is invaluable for Investors, they created 12 Investible Attributes. Traders can also use these Investible Attributes to analyse the underlying Strategy itself.

The Market Correlation Investible Attribute looks at the correlation between the underlying market and the trading strategy itself. It then ranks how much value the trader is providing.

Let’s explain in more detail.

Let’s say a trader has a long-only stock portfolio. The trader enters longs and then does nothing but sit and wait to see what the market does. If the market is bullish, the stocks go up, and the trading strategy does well.

However, if the market falls, the trading strategy loses money. This scenario would return a low Market Correlation score. The positive or negative return isn’t due to the trading strategy. It’s due to the underlying market being bullish or bearish.

Alternatively, let’s say the trader only longs the same stocks for 3 hours a day at London open. If the stock market declines overall, but the London session tends to open bullish, and the trader can capture these positive returns but avoid the fall of the market overall, the operational decisions of the trader are providing value to investors.

The trader is making decisions to try and outperform the underlying market. This results in the trading strategy having a higher Market Correlation score due to the trader not relying on the directional bias of the underlying market.

(Mc) measures the Correlation of the Strategy with the underlying market. How do you measure the risk of an underlying strategy?

Risk, in general, is a broad topic. There are lots of different types of risk. One of them is associated with the stability of the underlying Strategy, and this is where the Risk Stability investible Attribute excels.

Because the Risk Stability Investible Attribute ranks the consistency of the underlying trading strategy. A low (Rs) score would indicate that the underlying trading strategy has an unpredictable risk profile. Why does this matter?

If a trading strategy has inconsistent trade exposures, this can negatively affect the return distribution. What happens if a higher majority of losing trades have a more significant exposure?

You could have a potentially winning strategy that loses money. This concept was covered in the post about Van Tharp’s R multiples.

By equalising the risk of each trade, you increase the Risk engines ability to stabilise the risk for Investors.

This is a much more robust way of approaching how to size your trades.

Furthermore, a low (Rs) score combined with another Investible Attribute can indicate potentially dangerous trading behaviour. More on this in a future post

Did you know?

Darwinex created a stand-alone risk engine to actively manage the risk of a DARWIN independently of a DARWIN provider (Trader). It is this risk engine, amongst other things, that enables DARWINs to charge performance fees that are paid to the DARWIN Provider.

Did you also know?

You can make use of Darwinexs’ Investible Attributes without having a Darwinex Trading Account. All you need to do is create a free basic account and link your existing trading account from your current broker. Therefore there is no need to deposit any funds, just enter a couple of details, and you’re good to go.

Doing this allows you to analyse all of the Investible Attributes and see what areas of your Trading strategy are potentially hurting your returns.

You can find more instructions on how to do this here.

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:

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

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:

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.