Thursday, November 1, 2012

How to play correlation?

On August 31st, I wrote about correlation characteristics of some currencies and stocks.

I haven't previously mention connections between stock indexes.

It is worth to note that the correlation relationship between indexes is disturbed by different hours when markets are open. For example, the Frankfurt Stock Exchange closes at 15:35 UTC, while the New York Stock Exchange trades till 20:00 UTC. You can partially reduce this discrepancy by using index futures which trade longer hours.

Nevertheless the average n=25 correlation between daily changes of S&P500 and DAX index of the German stock exchange is around 0.25.

However, at the end of August it stood at 0.797, or very close to its historical maximum:

Fig. S&P500 - DAX n=25 correlation of daily changes, 2012-08-31

It has retraced since then to a little modest, but still pretty strong 0.59:

Fig. S&P500 - DAX n=25 correlation of daily changes, 2012-10-31

In the meanttime the value of S&P500 moved from 1406.58 to 1412.16 (+0.39%), while DAX changed from 6970.79 to 7260.63 (+4.07%).

Fig. S&P500 and DAX 1M, 2012-08-31, source:

Fig. S&P500 and DAX 3M, 2012-10-31, source:

Correlation is a mean reverting process. But taking advantage of it is not an easy task...
Fig. S&P500 and DAX 25 days correlations

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