Definition of 'Correlation Trading'
The key to correlation trading is understanding the principle of diversification; given some expected return, the volatility of a portfolio of securities is less than (or equal to) the volatility of a single security in that portfolio. This is based on Modern portfolio theory. The lower the correlation among the individual securities, the lower the overall volatility of the entire portfolio. This is due to the way in which variances behave when summing correlated random variables.
To buy correlation, investors can:
- Buy a portfolio of call options on the index and sell a portfolio of call options on the individual constituents of the index.
- Buy a variance swap on the index and sell the variance swaps on the individual constituents.
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