Indicator of the Month - Introducing the Correlation Coefficient

Correlation is the statistical means of determining whether the price of one security moves in direct relation to the price of a market index or another security. After entering chart duration, select the two securities to be used in the correlation analysis. For the purpose of illustration, we will select a chart of News Corporation Ltd and the NASDAQ Composite Index and evaluate the relationship between News Corporation Ltd and the NASDAQ over a one month period.

A chart of News Corporation Ltd. The price data of News Corporation is displayed in black and we have overlayed the
NASDAQ Composite Index in red.

Correlation analysis operates by plotting a scatter-gram of the closing prices of the first security against the closing prices of the other security or index. Once the points have been plotted, the straight line that best fits the points is computed and plotted. The line is computed using a least squares linear regression. MetaStock then displays the correlation coefficient.

Correlation coefficients range from zero to plus or minus one and provides an indication of how good the price relationship is between the two securities. Values near plus or minus one indicate that there is a strong relationship between the price movements of the two securities. Values closer to zero (-0.75 to +0.75) indicate poor correlation. If the coefficient is negative, it means that a negative price relationship exists (a price increase in one yields a corresponding price decrease in the other).

The Correlation Chart is most useful when there is a high degree of interdependence between two securities (i.e., correlation coefficient is greater than 0.9 or less than -0.9). Under these circumstances, a sudden deviation of the may indicate a change of market sentiment towards the stock. Such changes in sentiment are often the result of an unexpected change in earnings, a buy or sell recommendation from a major broker, takeover rumours, etc. It is always a signal to be wary.

In our example we can see that at various times during the month of January and February there was a strong relationship between the price movement of News Corporation and the NASDAQ. At other times however this relationship was less discernible. For those new to technical analysis, knowing where and when local securities are being influenced by market factors (such as movement in a leading index like the NASDAQ) provides an important edge to your analysis and as such the correlation coefficient indicator is an important tool in the analysts arsenal.