CorrelScan

CorrelScan is a general purpose correlation tool that helps you compare all items in a list to all the others.  Most technical analysis programs that allow you to run such correlation scans, for example TCScan+, allow you to see how one item compares to other items in a list.  This is useful when you have a particular item you are interested in, but if you are instead looking for good trades within a basket of items, for example in Pairs Trading, then you need a tool like CorrelScan.  A fully-functional trial version is available for download on our Download page and the current help file with more detail than provide below is available here.  Please note that, as with TCScan+, CorrelScan is an add-on to Worden Brother's TeleChart Stock Charting Program and so will only work if you have TeleChart installed on your machine.  A free trial version of TeleChart is available from the Worden site.

 

The primary statistical measure of how similar (correlated) two items are, is the Correlation Coefficient.  It can only have values from -1 to +1.  Values close to +1 indicate that the items behave very similarly, while values close to -1 means they behave in an opposite manner.  Values close to 0 indicate that the two items are not related at all.  Examples are provided below.

 

There are a number of ways you can use CorrelScan:

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You can trade sets of similar stocks off each other. If one stock starts a move, for example after some good news, you can trade closely-correlated stocks to it, knowing they will move in a similar way soon thereafter. If you played the primary stock directly you might only catch the tail-end of the move, whereas by buying its correlated partners you could catch a much larger part of the move. You would also lessen your risk by being more diversified. The chart below shows an example where two items are well correlated up to the time of the scan (indicated by the vertical dotted line) and then proceed to move the same after the scan date. Notice that the two items do not move perfectly in sync either before or after the scan date, but they generally follow the same direction - you will always need to allow some margin of error in these types of trades.

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You can trade dissimilar stocks off each other. If one starts trending up you can short another that is anti-correlated to it knowing that there is a good chance you will be right. The chart below illustrates an example - note the continued dissimilarity after the scan date.

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You can balance your portfolio, making sure that you have a diverse set of items that will not be affected by each other. In this case you select items that are not well-correlated with each other. The linkage chart below shows the components of the Dow Jones Industrials list, with the most similar items connected by lines. As described in more detail in the Help File, a balanced portfolio should consist of items selected from the outer edges of the chart, for example KO, HON, MSFT, JNJ and MMM in this example.

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You can find items that normally behave very similarly, but are currently not doing so. You can then take trades betting they will soon revert to normal behavior - this is known as Pairs Trading. An example chart is shown below. In the top pane is shown the price data of the two items and in the bottom pane is shown the relative price difference between the items (in terms of multiples of the average difference between them.) You can see that the items move more or less in sync until around February 2005, when they start to diverge more than 'normal'. The scan date, indicated by the vertical red line, is around May 2005 and this pair was highlighted because the difference between the items was almost 3 times the normal difference and the difference was starting to flatten out. This behavior, for normally well-correlated pairs, is an indicator that they may soon start to revert to normal behavior. You can see that the items indeed did turn around, so if you had shorted JNJ and bought HD (or their options) you would have made a good profit.

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You can find minimum volatility pairs, i.e., pairs where you take a long position in one of the items and a short position in another so as to reduce the volatility of your position. CorrelScan helps you to balance the risk versus the return for the pair. The chart below shows an example, where PFE was sold and MO was purchased. The green and red curves show the trade profit for each item and the black curve shows the average profit for the pair. You can see that if you had just purchased MO, you would have made $4,000 profit, but would have had to endure almost $1,500 changes in profit along the way. On the other hand if you had just shorted PFE, you would only have made $1,000 profit and had to endure $500 changes in profit along the way. On the other hand, the combined pair would have made you $2,500 profit, but more importantly, you would only have had to endure a maximum of around $500 profit change along the way, with a much lower average change than that. So you do not make as much as you could have - but you sleep a lot more peacefully!

 

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You can get an understanding of Market Structure.  Shown below is a more complex example of the linkage chart shown above.  This is for the last year of data for TeleChart's All Indexes list and shows those indexes that are most correlated with each other linked to each other.  The darkness of the line linking the items indicates the strength of the correlation and the color of the sphere indicates the percentage change over the last 30 trading days - yellow-shaded items are trending up and red-shaded ones trending down.  (The chart is a little cramped, but CorrelScan allows you to zoom into areas and roam your mouse around the chart to find out further details like correlations, Alpha, Beta, etc.)

Please visit our Download page to download a free fully-function trial version of CorrelScan.

 


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