Correlations Between Stocks and Between Sectors

Chris Rodarte from Pine River Capital Management and Tim Edwards from S&P Dow Jones Indicies teamed up for a discussion of Correlations Between Stocks and Between Sectors at CBOE’s Risk Management Conference in Geneva Switzerland.

Edwards kicked things off with an overview of the history of correlation in some major markets and noting the strong relationship between correlation and volatility.  He noted that volatility moves up when markets are correlated, but at times the magnitude of the move in volatility is greater than at other times.   He noted in the current market environment what should be individual stock events (think VW) have a ripple impact on the rest of the associated market.

He then moved on to dispersion and how it relates to performance.  Edwards noted that historically when dispersion increases that momentum and growth stocks outperform.  Conversely when dispersion decreases equal weighting or rebalancing strategies and value oriented stocks outperform.

Rodarte started his part of the session noting that volatility is obviously high.  He refers to correlation as an asset class which caught the attention of the room.  His first slide noted that index realized correlations have been trending higher over time.  With respect to selling volatility, he noted that even though VIX is fairly high, the risk of short volatility strategies is elevated in the current market.  This thought has come up a few times over the past couple of days at RMC.

He offered an example of using listed options to take advantage of the implied correlation being over 100%.  The trading example involved selling an at the money straddle using SPY options and then buying straddles on nine broad sector oriented ETFs (XLY, XLP, XLE, XLF, XLV, XLI, XLK, XLB, XLU).  The weighting of the long straddles is equal to the sector’s weightings in the S&P 500 with the result being zero delta at inception of the trade.