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Trading Correlated Markets

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Capitalize on sectors in lock step.

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Today I read some interesting observations from Bespoke. See them here:

"We recently calculated the correlations between the S&P 500, its ten sectors, gold, oil and the 10-year Treasury note over two different time periods. The first matrix highlights the correlations (between daily % changes) from July 2007 to now. The second matrix highlights the correlations over the last 10 years, and the third matrix compares the difference between the two sets of correlations. In the third matrix, numbers highlighted in green indicate an increase in correlation, while numbers highlighted in red indicate a decrease in correlation (or more negative correlation).

Since July, the market has had a change in personality from cool, calm and collected, to volatile, crabby and downright bipolar. Based on our correlation matrix, it's easy to see that sectors and asset classes (with the exception of Treasuries) have become much more correlated. All sectors have become more correlated with each other and the S&P 500 as a whole. Most have become more correlated with gold and oil as well. This new environment has put an even greater emphasis on macro-level investment strategies, because diversification is not really providing much diversification right now
."


What's it all mean? Well you can boil index volatility down to two basic factors. One is the volatility of the component stocks, the other is the correlation between those very stocks. And they can very much offset each other. Imagine a world where half the stocks were moving violently and basically trending in one direction, and the other half was moving violently the other way. Index volatility would be very low as the moves would pretty much offset each other.

What we have now is the opposite. Stocks aren't that cosmically volatile, but they are all moving in relative unison. Ergo index volatility is theoretically *high* relative to individual stock volatility.

What does it suggest? Well, you could *fade* the current environment by selling index volatility and buying individual stock, or sector, volatility. This kind of correlation does not last forever; at some point better *themes* will emerge. One problem though; there's no particular price edge on the options board.





The upper chart is SPY volatility, the lower is for XLY. I just picked one sector spider, but they all look pretty similar. And identical to SPY itself.

So I like the concept of fading this environment. But I would look at it as alternatives, as opposed to a combo trade. In other words, if you feel the urge to go long gamma in something resembling an index, I would choose a sector or two or three and go with that as opposed to the SPY. And probably a narrower based ETF than these as my friend Mike from Options Trading the Smart Way chimes in. And conversely, the SPY itself is a better gamma short now than individual names or sectors.

Position in SPY
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