Correlation, in the finance and investment industries, is a statistic that measures the degree to which two securities move in relation to each other.

Correlations are used in advanced portfolio management. Correlation is computed into what is known as the correlation coefficient , which has value that must fall between -1 and 1. This implies that as one security moves, either up or down, the other security moves in lockstep, in the same direction.

Calculating Covariance For Stocks

A perfect negative correlation means that two assets move in opposite directions, while a zero correlation implies no relationship at all. Small-cap stocks have a positive correlation to that same index also, but it is not as high, generally around 0. However, put option prices and underlying stock prices tend to have a negative correlation.

As the stock price increases, the put option prices go down. This is a direct and high-magnitude negative correlation. Investment managers, traders and analysts find it very important to calculate correlation, because the risk reduction benefits of diversification rely on this statistic.

How to Calculate Stock Correlation Coefficient: 12 Steps

Financial spreadsheets and software can calculate the value of correlation quickly. There are three steps involved in finding the correlation. The first is to add up all the X values to find SUM X , add up all the Y values to fund SUM Y and multiply each X value with its corresponding Y value and sum them to find SUM X,Y:. The same must be done for the Y values:.

Noting that there are seven observations, n, the following formula can be used to find the correlation coefficient, r:.

Dictionary Term Of The Day. A measure of what it costs an investment company to operate a mutual fund.

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