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Are Correlations Really that High?

Adam Warner over at the DoR (now part of the Stocktwits family) has  a post up about how high correlations are in stocks. We've seen this giant macro conveyor belt drive the risk trade on and off for the past 18 months, so it is reasonable that liquidity and performance will be correlated across the board. This can also be a fear gauge, as no matter how good of a stock picker you are, it's no fun when correlations head to 1-- see 2008 for instance. Read through for the whole post.

But the measure used may not be indicative of the entire market. The original source (MKM Partners) uses JCJ as a measure of correlation. This is known as an implied correlation index, and it's very helpful for firms who are tryinig to run dispersion trading/vol arb books. However to Johnny Retail it might be a little more misleading.

JCJ (and KCJ) are derived from looking at the top 50 components on the S&P and their options-- you can see the actual whitepaper here -- if you have insomnia, this will cure it!

Here's the thing-- we already know that a lot of the large companies are going to have high correlations. Unless there's fresh news in a sector or a company, they generally run on the same track-- the futures arb firms make sure of that.

So the death of stock picking? Probably not. The high beta small caps aren't really included in this reading, and so I'm more inclined to think that correlations really aren't running that hot-- especially when you see ARST or FIRE from the past week. Besides, stock picking is much more sexy when you buy DDRX instead of XOM.

by Steven Place

Steven Place is the founder and head trader at investingwithoptions.com/