Using Correlations to Make Money

03/18/2013 8:00 am EST

Focus: OPTIONS

Have you ever wished that you could undo a loss that you just took in the market? Of course; everyone wishes they could do that, writes Greg Loehr of OptionsBuzz.com.

Here’s an example of using correlations to possibly accomplish the idea of “undoing” a loss—or simply just to make money.

Assume that you own shares of Garmin (GRMN), and you wake up to see that the stock is down 10% due to their earnings report. Well, actually, it wasn’t just the earnings report, but the CEO basically saying that the industry is still in a secular decline. This happened February 20 of this year.

If I see one company taking a hit because of industry-wide problems, then I look at other companies in the same sector. Garmin makes GPS devices, and some pretty cool ones at that. But have you used Google Maps yet? It’s just as cool; and it’s free. I can see why the GPS industry might be having troubles. And if GRMN is taking a hit, what other stock(s) might also feel the heat?

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Yahoo Finance lists Trimble Navigation (TRMB) as one of GRMN’s competitors. Simply being in the same industry might be enough for me to consider a bearish trade for TRMB, but what else can I consider? Correlation.

Depending on the time frame used, a correlation calculator indicates that the correlation between these two companies is around 0.80. So one can broadly state that if GRMN is down, there’s an 80% chance that TRMB will also move lower by a similar percentage amount. Of course, there are no guarantees, but it might add some confidence to your decision to place a bearish trade on TRMB.

On the 20th, when GRMN opened lower by 10%, TRMB opened a little lower. This is when I issued a Trade Alert to buy the April 60 puts for $1.65. Four days later this trade doubled in value to $3.30 as the stock dropped by 7%.

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Knowing your stocks (and their industry competitors) certainly helps in your trading and potentially can provide other opportunities for hedging or outright speculation. In this instance, bad news for one company led to profits on another company based in part on their correlation.

By Greg Loehr of OptionsBuzz.com

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