The problem with correlation is that relationships between instruments change with time and correlation potentially fails you when you most need it: in times of crisis. You might set risk management thresholds based on correlation levels “pre-crisis”, which blow out when the crisis arrives with most products “correlating” more than they have in the past and generating larger exposure than anticipated with correlation analysis…

To quote Taleb: “Anything that relies on correlation is charlatanism” – probably a bit exaggerated (taleb-style) but the paragraphs on correlation in Black Swan are interesting.

That chart and article “seem” to suggest that S&P, DJIA will get back in tandem with the Nikkei – a basic “pair trading” strategy, which relies on mean reversion rather than Trend Following…
And we all know what can happen to some mean reversion strategies (Amaranth, LTCM, Niederhoffer, etc.)

Correlations change, and systems have to be built for change. This is not about tight gloves, but rather loose mittens.

Just to second Mike on this… it’s only natural for humans to seek certainty and precision over approximation and estimation. If one visits the forum David mentions one may easily see that for many systematic traders the drive for measurement often replaces the need for discipline and continuous assessment of behavior. In my own experience a system is only useful if it is not held with too much rigidity.

That’s why I find trendfollowing so valuable…these philosophical questions become moot as simply allowing a market to takes its natural course from A to B in its usual inefficient manner and jumping on board with proper money management will eventually lead one to riches.

I quit reading the business pages three years ago and have done extremely well ever since, especially during 2008. I concluded that riding even a single market up or down and staying out when it’s sideways made a lot of sense.

If I were managing other people’s money, I would care about correlation to some degree in anticipation of that “black swan event” that everyone worries about, but for myself, I rely on stops.

@Mike – I agree, you probably need to look at correlation from a worst-case historical scenario to set your risk management accordinlgy (ie make sure that the risk management is not “optimised” but rather allows you to stay alive when it hits the fan and correlation spikes up during crisis times..

@David, would you have the link to the TB forum thread you are referring to please?

See also Pages 94 – 98 of The Complete Turtle Trader…the turtles were taught to be aware of correlated trades in their portfolio.

You don”t have to know what’s next. You play the probabilities. I personally don’t like staring at a quote screen so I play the long trends, trading maybe 10 times per year. As Seykota says, you can spot a trend by standing back from the chart. And if you’re in doubt about which way it’s going, then it’s going sideways.

I see a lot of traders staring at their screens all day and seeing lots of trees but no forest. They typically overtrade and panic at the lows and sell their profits short…the opposite of what they should be doing if they could just stand back and keep their perspective.

I”m a “math guy” but I find the math I use basically confirms this simple visual principle.

Cheers

1. Michael Covel Says:
August 5th, 2010 at 10:51 am
Correlations change, and systems have to be built for change. This is not about tight gloves, but rather loose mittens.
I couldn’t agree more. I would like to add that, for system trading portfolio of instruments, positions have to become correlated to some degree at certain periods in order to make money. These periods I see as run ups and run downs in equity. Not wanting correlation in portfolio makes as little sense as saying that we want to make money only on a part of any given position. I open every position with an idea to make money on it thus if for example portfolio holds 10 long and 4 short positions I want all of them to be correlated and make money for me at the same time at all times. However I have to also admit to my self that the opposite may happen and build into the systems appropriate risk controls to deal with the exact opposite scenario. In 2008 we saw trend followers who understood this make a lot of money as virtually all futures markets moved up and then down in very correlated fashion.