Many traders lose their initial capital on stock market.
This is not always due to inefficient stock trading strategy but because the traders often ignore some of risk management rules or do not follow them at all.
Loss trades are part of work for every trader and it is important to control possible loss in each trade.
I will not write about necessity to setup stop loss and restrict volume of each trade by some percentage value of your trading balance.
It is assumed that it is an axiom for every trader.
In this article we would like to understand how the stock correlation can make the risk management more effective.
Stock Correlation is a floating number between -1 and +1.
It shows degree of similarity between two stocks in their price changes.
"1" means the stocks are absolutely identical in their price changes.
Practically 1 is never achieved.
A share has correlation 1 with itself.
"-1" means that shares move in absolutely opposite directions.
It is also only a theoretical value, but stocks can have correlation that converges to -1 in practice.
"0" means that no any dependencies between two shares.
"0" is very rare, almost theoretical value because it is impossible to find absolutely independent shares.
All shares depend on entire market mood and in turn always correlate to each other.
So how the correlation relates to risk management? Traders usually do not trade only one stock.
They keep opened positions for several stocks.
This group of stocks is usually called "trading portfolio".
And this is a good practice because it is not reasonable to invest all the money in only one stock.
It is safer to invest the money in trading portfolio with many stocks.
By this you realize hedging technique.
If one stock goes down it will not affect entire investment significantly because it would be only a small part of your trading portfolio.
How a stock can be added in the portfolio? One of the important criteria would be a low correlation with other stocks in the portfolio.
Only in this case, when the correlation between two shares in the portfolio closes to 0, you are hedging your assets.
Opposite to low correlated stocks, high correlated stocks, with correlation value close to 1, move in the same direction almost all the time and you lose benefits of portfolio usage.
Such situation can be compared with buying one share with the summarized portfolio volume.
But there is a high risk to lose all the money if the share drops down significantly.
So we can conclude that one need to check correlation values before adding new stock in the trading portfolio.
This is not always due to inefficient stock trading strategy but because the traders often ignore some of risk management rules or do not follow them at all.
Loss trades are part of work for every trader and it is important to control possible loss in each trade.
I will not write about necessity to setup stop loss and restrict volume of each trade by some percentage value of your trading balance.
It is assumed that it is an axiom for every trader.
In this article we would like to understand how the stock correlation can make the risk management more effective.
Stock Correlation is a floating number between -1 and +1.
It shows degree of similarity between two stocks in their price changes.
"1" means the stocks are absolutely identical in their price changes.
Practically 1 is never achieved.
A share has correlation 1 with itself.
"-1" means that shares move in absolutely opposite directions.
It is also only a theoretical value, but stocks can have correlation that converges to -1 in practice.
"0" means that no any dependencies between two shares.
"0" is very rare, almost theoretical value because it is impossible to find absolutely independent shares.
All shares depend on entire market mood and in turn always correlate to each other.
So how the correlation relates to risk management? Traders usually do not trade only one stock.
They keep opened positions for several stocks.
This group of stocks is usually called "trading portfolio".
And this is a good practice because it is not reasonable to invest all the money in only one stock.
It is safer to invest the money in trading portfolio with many stocks.
By this you realize hedging technique.
If one stock goes down it will not affect entire investment significantly because it would be only a small part of your trading portfolio.
How a stock can be added in the portfolio? One of the important criteria would be a low correlation with other stocks in the portfolio.
Only in this case, when the correlation between two shares in the portfolio closes to 0, you are hedging your assets.
Opposite to low correlated stocks, high correlated stocks, with correlation value close to 1, move in the same direction almost all the time and you lose benefits of portfolio usage.
Such situation can be compared with buying one share with the summarized portfolio volume.
But there is a high risk to lose all the money if the share drops down significantly.
So we can conclude that one need to check correlation values before adding new stock in the trading portfolio.
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