This filter selects your instruments based on how correlated they are to an index (during a specified period). Correlation describes the strength and direction of the relationship over that period. A high positive correlation does not require the instrument and index to move by the same number of points or the same percentage.
This is a good filter to make your portfolio mimic the behavior of a certain profitable index. For example, if S&P 500 is on a strong rally, you want to select instruments that perform the same way as that index. Or the reverse, you will sell Positions whose behavior start deviating from the index (remember that an instrument’s correlation with an index continuously changes).
Correlation alone does not determine whether an instrument will outperform an index or how much it will gain or lose. A historical correlation value is not a guarantee of the future relationship.
Do note you may be tempted to use a stock or an ETF, instead of an index. For example, if you know Stock A’s performance is gaining strong, you want to look for other stocks that mimic this behavior. But beware that a stock’s performance is much more variable than an index, so your backtesting result (going back decades past) may not reflect the current good performance of that stock, which means your strategy may be a fluke for the longer term.
1. The first parameter defines the lookback period for the instrument’s correlation to an index. The selected period determines which observations are used to calculate the correlation. Changing the period can change the result.
2. The second parameter defines what index (or another instrument) to compare against.
Keep in mind, you can’t enter a delisted instrument here (those indicated by a number suffix inside square brackets). Otherwise a warning appears and you can’t backtest the strategy:
3. The third parameter defines whether the instrument must be “Above” or “Below” the threshold correlation value to be considered as a buy/sell.
4. The fourth parameter defines the threshold correlation value for these instruments to be considered. A value of 1 indicates a perfect positive relationship. A value of 0.2 indicates a weaker positive relationship over the selected period; it does not measure how much the index causes the instrument to move.
You can also input a negative value. A value of -1 indicates a perfect negative relationship, with the two series moving in opposite directions. It does not mean their point changes are equal.
For example, an “Above” threshold of 0.8 selects instruments with a strong positive correlation over the chosen period. That threshold alone does not establish portfolio diversification or protection from market declines.
Note:
Once this filter is applied, a correlation indicator appears on the chart below the Price Chart (at the Instrument Tab). It shows how correlated the selected instrument is to the index, during the specified period.
