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Correlation Strategy
The Smart Profits Report: Issue #290
Thursday, March 9, 2006
Correlation Strategy: Identify the Tide And Ride It To Profitability
By Dean Albrecht
Investment Panelist, Mt. Vernon Research
In wrestling, where the head goes, so goes the body. Similarly, where the markets and indexes go, so go the stocks.
When indexes are choppy and directionless, so are stocks. Let’s take a look at the all-important “correlation strategy” to determine the direction of the markets when we’re searching for ideal entry and exit points. Why?
When the markets move, so do most stocks. As a rule, I like to see a move of 3.5% to 9% prior to entering a position.
Easy As Watching A School Of Fish
For you fishermen, if you see the Spanish mackerel swimming in one direction, there is a good chance the kingfish are not too far behind.
The trick is to have an entry point and identify which sector is leading the stocks within them. That means spotting the move of a stock to the upside or downside and the point at which the move is likely to slow down, end and turn around.
Below is a shot of the XBD. XBD is the symbol for the Broker Dealer Index. It started on a tear during the last week of October 2005, and has been going quite strong since then.
Now, check out the chart of Ameritrade (Nasdaq: AMTD) below. It started on an up-move at about the same time as the Broker Dealer Index. It followed suit and continues to be highly correlated to the Broker Dealer Sector.
As you can see below, Lehman Bros. (NYSE: LEH) started the move at the same time and has continued to follow suit.
Clearly, correlation is a very strong and valuable tool to determine the entry or exit point of a position.
Correlation Strategy: How to Pick the Right Stock
Ask yourself this question: Are the stocks within the sectors going up or down, and are they following the sectors? If the answer is yes, then you stand an excellent chance of being right about your direction of the stock.
How do we pick a stock in our correlation strategy?
Let’s assume the markets are going up. Let’s also assume we have a sector that is trending up, like the Broker Dealer Sector in the first graph. Then we identify a highly correlated stock or group of stocks that follow the sector and we buy them using the sector as our lead. When the sector finishes its run and retreats, it’s time to sell.
Good Trading,
Dean
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Today’s Smart Profits Cribsheet
- Speaking of fish, do you know the meaning of “underwater” in the options trade? Definition: Also referred to as out of the money, underwater is the circumstance an option is in when its strike price is higher (call) or lower (put) than the market price of the underlying stock. For more useful terms and phrases, see our Smart Profits Glossary.
- Getting a sharper angle on market sectors can pay off handsomely. To find out how to hone in and isolate option-trading opportunities in a sensible way… so that you know why you’re trading (long or short) and how to give yourself the best chance at success, check out Smart Profits #253, Options Trading Strategy: A Five-Question Screen to Find the Perfect Option.
Related Articles:
- Fundamental Analysis - Three Screens For Technical Traders
- Options On ETFs - Increased Safety and Profit Potential
- The CBOE: The Website Every Options Trader Should Know
