ETF Trading, Risk and the Role of Correlation
Last week we looked at how Leveraged and Inverse ETFs behave. If you missed this, you can find it on my research website www.ConnorsResearch.com.
Another piece of understanding how ETFs trade and what they mean to you is looking at the correlation of ETFs. If you are long multiple energy ETFs at the same time, you are likely in highly correlated ETFs which will all move together. If you’re right, you’ll likely do well. If you’re wrong, you could see outsized losses.
In order to lessen the risk in your ETF trading, you ideally want to be in as many low correlation ETFs as you can.
Recently a member of our Swing Trading College sent me a link to a free site that does correlations for you. The site is here.
When you use the site (and this is a big part of today’s trading lesson), make sure you set the time period to as short a period as possible (their shortest is 6 months). Ideally you want go even shorter than this but this is the shortest they offer.
Why go back so short? Because correlations constantly change (they’re dynamic). It amazes me when I see analysts discussing 3-5 year correlations. It’s nonsense. Correlations change much quicker than that and its best to apply the shortest time frame available to get the truest reading.
Ideally we like to look back as short as one month for accurate correlations, though going a little further back is fine. The key is to study the correlations of the ETFs you’re trading and then make sure they reflect the fact that ETF correlations are dynamic and change quite often. I hope you find the site useful.
Special Notice: Thursday March 4, 2010 at 4:30 PM, EST, I’ll be conducting a free presentation about TradingMarkets Swing Trading College.
If you would like to attend the presentation, please call 1-888-484-8220 ext. 1 or click here to reserve your spot.
Larry Connors is CEO and Founder of TradingMarkets.com and Connors Research.