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Asset Correlation – Uncorrelated Positions Summary

Introduction Summary

Correlation can be used to forecast future trends and to manage the risks within a portfolio, various asset classes can be utilized to search for little or negative correlations, and beta weighting allows you to assess all of your positions relative to a move in the market (when weighted to SPY) or a specific symbol. 

Benefits of Uncorrelated Positions

Uncorrelated positions allow for a reduction in risk as a portfolio’s systemic risk cannot be eradicated but can be mitigated using a range of assets. Unsystematic risk can be eliminated through diversification, particularly with lower correlated stocks. Uncorrelated positions also allow for access to other markets where greater opportunists may lie. Being product-agnostic can allow for only the most favorable trades to be taken. Lastly, as downside moves tend to be sharper than upside and limiting them can minimize drawdown, holding a variety of positions is critical for capital preservation and controlled appreciation. If you know the correlation between two underlying and a fixed index, you can compare the two underlying. This is how beta-weighted deltas can be used in a dynamic portfolio to control exposure. One strategy to provide positions with no correlation is trading the spread between two underlying such as pairs trading using correlation. 

Trading Correlation

Pairs trades offer uncorrelated positions based on a reversion to the mean. One finds two highly correlated underlying that have recently diverged and go long the underperforming one and short the outperforming one. This strategy is market neutral if volatility is weighted and capitalizes on the spread narrowing. 

Uncorrelated positions can reduce a portfolio’s risk without necessarily limiting returns. Having traded in various underlying, sectors, and asset classes and strategies can help limit risk and exposure.