Correlation
Correlation measures how closely two prices move together, from +1 (always together) to −1 (always opposite); highly correlated positions add up to one bigger bet.
Owning five positions does not mean you have five separate risks. If they all rise and fall together, you effectively have one large position. Correlation measures how closely two assets move together, and it is the hidden variable behind diversification, hedging and many surprise drawdowns. This entry explains the scale from −1 to +1, how to use it when building positions, and why correlations change exactly when you need them most.
- Category
- Risk Management
- Reading time
- 4 min
- Also called
- Correlated assets, Correlation coefficient, Positive correlation
- Updated
Correlation in plain words
If two stocks almost always rise and fall on the same days, their correlation is close to +1.1 If one tends to rise when the other falls, it is close to −1. If there is no relationship, it is near 0.
For traders, the practical point is simple: positions with high positive correlation add up. Three long positions in similar tech stocks behave much like one position three times the size. See Risk Stacking.
How to use correlation, step by step
Use returns, not prices
Correlation is measured on daily or weekly percentage changes, not on price levels.
Pick a window
60 or 90 trading days is common; longer windows are steadier, shorter ones show recent changes.
Read the number
Above about 0.7: strongly related.2 Around 0: little relationship. Below −0.5: tend to move opposite.
Group related positions
Treat strongly correlated positions as one when adding up risk. See Portfolio Heat.
Look for real diversifiers
Low or negative correlation is what makes diversification and hedging work. See Diversification and Hedging.
Recheck in stress
Correlations often rise sharply in sell-offs; test how your positions behaved in past crashes.
Worked examples
Example 1 — Three positions, one bet
StackedA trader risks 1% on each of three semiconductor stocks with pairwise correlations around 0.85. A sector-wide sell-off hits all three stops on the same day.
| Planned risk per trade | 1% |
| Actual loss in one day | ≈ 3% |
With high correlation, three “independent” trades behave like one trade risking 3%.
Example 2 — Diversification that works
DiversifiedA portfolio holds two assets with equal weights and the same 20% volatility. Correlation is 0.2.
| Portfolio volatility | 20% × √((1 + 0.2) ÷ 2) ≈ 15.5% |
| If correlation were 1.0 | 20% — no benefit |
Low correlation reduced volatility by about a quarter without lowering expected return.
Example 3 — Correlations rise in a crash
StressTwo stock indices from different regions usually have a correlation of 0.5. During a global sell-off, their daily moves line up and correlation jumps to 0.9.
| Normal times | Partial diversification |
| Crisis | Little diversification left |
Diversification based on calm-period correlations protects less in a crisis. See Risk-On and Risk-Off.
Reading correlation values
| Aspect | Meaning | Portfolio effect |
|---|---|---|
| +0.8 to +1.0 | Move almost together | Adds up to one large position |
| +0.3 to +0.7 | Related, not identical | Some diversification |
| −0.3 to +0.3 | Little relationship | Good diversification |
| −0.7 to −1.0 | Tend to move opposite | Can act as a hedge |
Why traders watch correlation
Position limits
Capping total risk in correlated groups.
Diversification
Choosing assets that do not all move together.
Hedging
Finding instruments that move against a position. See Hedging.
Pairs trading
Trading the spread between two highly related assets. See Pairs Trading.
Advantages and disadvantages
Advantages
- Reveals hidden concentration in a portfolio.
- Simple scale from −1 to +1.
- Guides diversification and hedging decisions.
Disadvantages
- Changes over time, often rising in crises.
- Measures linear relationships only.
- Depends on the window and data frequency.
- Correlation is not causation.
Going deeper
Read as far as you need. Each level builds on the one before it.
Correlation is about direction, not size
Beginner
Two assets can be highly correlated even if one moves twice as much as the other. The size relationship is measured by beta. See Beta.
Correlation in crypto
Intermediate
Many crypto assets are strongly correlated with Bitcoin, so a basket of altcoins often behaves like one leveraged Bitcoin position.
The diversification formula
Advanced
For two equally weighted assets with the same volatility σ and correlation ρ, portfolio volatility is σ × √((1 + ρ) ÷ 2). At ρ = 1 there is no benefit; at ρ = 0 volatility falls by about 29%; at ρ = −1 it could in theory be eliminated.
Common mistakes
Counting positions, not risks
Five correlated trades are one risk.
Trusting calm-period correlations
Stress tests matter more.
Using price levels
Measure correlation on returns.
Assuming stability
Recheck correlations regularly.
Check your understanding
Test yourself before moving on. Each answer comes with an explanation.
Key points to remember
- Correlation runs from −1 (opposite) to +1 (together).
- Highly correlated positions add up to one larger bet.
- Low correlation is what makes diversification work.
- Correlations tend to rise in sell-offs.
- Measure on returns, and recheck regularly.
Frequently asked questions
What is a high correlation?
Can correlation change?
Does negative correlation guarantee protection?
Further learning
- Diversification
How correlation is used to reduce risk.
- Hedging
Using negatively correlated positions.
- Risk per Trade
Why correlated trades need combined limits.
- Drawdown
What stacked correlated losses do to an account.
Sources
This article is written in our own words. The sources below support the specific facts, rules and figures marked with a number in the text. Links open the original publisher’s page.
- StockCharts ChartSchool. Why and How To Use Correlation (opens in a new tab) Checked .
- StockCharts ChartSchool. Correlation Coefficient (opens in a new tab) Checked .
Read more elsewhere
- Trading Metrics (our sister site): Correlation Matrix (opens in a new tab)
Educational content, not financial advice. Examples use hypothetical prices and simplified costs; actual fees, margin rules and regulations vary by broker, market and country. Trading Metrics is our sister site, under the same ownership; we are not affiliated with any other publisher linked above. Last reviewed . Report an error or request a source credit.