In finance, correlation trading is a strategy in which the investor gets exposure to the average

correlation In statistics, correlation or dependence is any statistical relationship, whether causal or not, between two random variables or bivariate data. Although in the broadest sense, "correlation" may indicate any type of association, in statisti ...

of an index. The key to correlation trading is being able to predict when future realized correlation amongst the stocks of a particular index will be greater or less than the "implied" correlation level derived from derivatives on the index and its single stocks. One observation related to correlation trading is the principle of

diversification Diversification may refer to: Biology and agriculture * Genetic divergence, emergence of subpopulations that have accumulated independent genetic changes * Agricultural diversification involves the re-allocation of some of a farm's resources to ...

, which implies that the volatility of a portfolio of securities is less than (or equal to) the average volatility of all the securities in that portfolio (This has nothing to do with

Modern Portfolio Theory Modern portfolio theory (MPT), or mean-variance analysis, is a mathematical framework for assembling a portfolio of assets such that the expected return is maximized for a given level of risk. It is a formalization and extension of diversificat ...

and follows from Statistics 101, definition of portfolio variance). The lower the correlation amongst the individual securities, the lower the overall volatility of the entire portfolio. This is due to the way in which variances behave when summing correlated random variables. To sell correlation, investors can: * Sell a

call option In finance, a call option, often simply labeled a "call", is a contract between the buyer and the seller of the call option to exchange a security at a set price. The buyer of the call option has the right, but not the obligation, to buy an ...

on the index and buy a portfolio of call options on the individual constituents of the index. Although typically in practice, the trader would choose straddles instead of calls to minimize delta risk as its often not feasible to perfectly replicate the index with single stock options.; * Sell a

variance swap A variance swap is an over-the-counter financial derivative that allows one to speculate on or hedge risks associated with the magnitude of movement, i.e. volatility, of some underlying product, like an exchange rate, interest rate, or stock index ...

on the index and buy the variance swaps on the individual constituents; this particular kind of

spread trade In finance, a spread trade (also known as relative value trade) is the simultaneous purchase of one security and sale of a related security, called legs, as a unit. Spread trades are usually executed with options or futures contracts as the legs, ...

is called a variance dispersion trade. * Sell a correlation swap. In practice, exchange-traded funds (ETF's) are sometimes chosen instead of indices.

See also