Correlation Risk: Risk Management Tactics

Correlation Risk is the risk associated with having several positions in too many similar markets.

Diversification is a method used by many successful traders to mitigate their risks. However, true diversification requires having positions in markets that don’t move in tandem.

Markets that are part of the same sector or group are usually very highly correlated or move together. For instance, in the energy sector, if you were long crude oil, heating oil, gasoline and gas oil all at the same time, this would be a form of overtrading.

There is a high probability that these markets will move up and down together. If you are risking 3% per trade, this will equate to a 12% exposure to the energy sector and can quite possibly be very similar to risking 12% in a single position.

Correlation risk can be very dangerous to a trader’s success. Successful traders know they need to be wary of overtrading. They limit their exposure to market sectors. By limiting your positions within a sector or group of markets, you will be actively guarding against higher correlation risks.

Let’s say that you trade a strategy that has a 50% chance for a trade to be a winner. If you are in one trade, of course, the chance of the trade being a loser is 50%.

If you happen to take on an additional trade in a truly independent market (not in the same sector), your chance of losing on both trades is 25% (50% x 50%). With three independent markets, your chance of losing on all three trades is 12.5% (50% x 50% x 50%).

As you can see, the chance of your open positions or your entire portfolio going against you diminishes if each trade is in a non-correlated market.

If you have positions in two trades in perfectly correlated markets, using the above system, your chance of both trades going against you is still 50%, but the loss will be twice as much (if you risked the same amount on each trade).

If you add a third trade in another perfectly correlated market, the chance the three trades will be losers is still 50%. However, now the loss will be three times as much (again, if your risk was the same in each trade).

Of course, this example has been illustrated with an even chance of winning and losing and with totally independent or perfectly correlated scenarios. In real world trading, every market will have a correlation coefficient between each market and itself, and so the formula for calculating your correlation risk is a bit more in depth.

The purpose of the example, however, is to stress the importance of avoiding having too many positions in highly correlated markets. A simple way to achieve this is to limit your exposure to each market sector.

Commodity Trading Solutions offers strategies that will manage the correlation risks as well as many other risk exposures for your account.

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