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ETF Correlations Matter

A recent post over at The Reformed Broker made a great point about the two things that are never cited in the mainstream financial media - time frame and position sizing. These are much less sexy topics than the proverbial "pointing at the fence where you're going to hit the home run" sort of trading machismo.

In addition to time frame and position sizing, correlation is another parameter to add to the overlooked list. While diversification gets the occasional nod, most retail investors, when pressed, would admit that they can't ell you how diversified they really are, let alone quantify the diversification.

Even more sophisticated traders, with a method that provides signals, often fall prey to trading stocks and ETF's with high correlations (particularly after a market pullback). Following proper position sizing and risked 3% on long positions in SPY and XLK is essentially the equivalent of risking 6% in either one of those ETF's, given their 94% correlation. Without monitoring correlations, which of course are not static measurements, you might as well disregard position sizing as well.

ETF correlations between GLD and SPY

There are many helpful online tools to quickly measure correlations, from pair comparison tools like the one at etfreplay (pictured) to more robust grid views of ETF portfolios.

Make correlation measurement part of your trading practices.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.