Covariance & Correlation

Covariance indicates if two separate variables tend to move in the same direction together over a specific time frame. In investments, covariance shows if two separate assets move together. Positive covariance indicates yes, while negative covariance indicates no. Correlation indicates the degree or strength which they move together. If two separate assets have 100% correlation, they will move together in perfectly equal degrees. If they have 0% correlation, there is no relation between them. If they have -100% correlation they will move perfectly opposite to each other. If seeking diversification, reduce the positive correlation of assets within the portfolio, then you’re not at risk of taking losses from all assets at once.

This is where the benefit of short selling appears. By short selling some assets while buying other assets, you can profit from assets that are inversely (negatively) correlated by purchasing a rising asset and short selling an inversely correlated asset. Profits from short sales cancel out or reduce losses when markets crash if both assets move down. In exchange, I gain the risk that short sold assets will sharply move up in price. To avoid this risk, I only short sell fundamentally “terrible” assets under bearish pressure from economic trends I’m completely certain few people want. There’s still a risk of an acquisition offer causing a huge price jump, but these events are fairly rare. Please note these statements are a potentially gross oversimplification of Long/Short equity systems. Don’t short an asset only because it’s inversely correlated to an asset rising in price. Stack many odds in your favor assuring success before moving, including economic, fundamental, technical, and quantitative trends.