Statistically speaking, two sets of data or two variables are said to be considered as correlated if there exists a statistical relationship (linear interdependence) between the two datasets or two variables. If two data sets or variables have a strong statistical relationship between them, they can be said as highly correlated. Investopedia defines this indicator as a measure the degree of correlation between two stocks. The value of the coefficient varies from -1 to +1. For pairs trading, we should choose a pair of different stocks with positive correlation, i.e. value of correlation coefficient indicator will be between 0.00 to 1.00. The closer to 1, the better. We use this coefficient in pairs trading strategy. Kite charts are equipped with this indicator as well.
How to set up Correlation coefficient Indicator in Zerodha Kite?
- Go to MarketWatch.
- Choose the stock you are going to trade.
- Right click on the stock and select chart from graphic icons.
- Chart window of the stock opens.
- Go to studies. Select studies.
- Go to Coppock Curve and click on it.
- A small window opens with default parameters of the indicator.
- Once the parameters are selected, the Done command is chosen, the parameters window goes off the screen and the indicator is plotted on stocks price.
How to trade intraday using Correlation coefficient Indicator?
- The indicator shows price trend and trading opportunities.
- The picture above shows the correlation between SBIN (State Bank of India) and ICICI Bank.
- The chart shows 1 min. timeframe.
- The strategy shows the price trend. Understanding price trend from this indicator is important before creating a position.
- Create short in SBIN and a long position in ICICI Bank when the correlation is above 0.5 and closer to 1. Make the trades simultaneously.
- Exit when the price reverses and correlation goes below zero. Both the exits have to be done simultaneously. Pairs trading strategy follow mean reversion theory.
- The indicator works well in daily time frame creating buying and selling opportunities simultaneously. For pairs trading, other indicators are also used in conjunction this coefficient.
The Correlation Coefficient indicator can also be used to determine the correlation between a stock and an index or a stock with an exchange-traded fund (ETF). This indicator is positive when both securities move in the same direction, either up or down and it’s negative when both securities move in an opposite direction. A reading above 0.5 denotes a strong correlation while any reading below -0.5 denotes a very wide divergence.