Correlation and portfolio exposure

Risk does not add up trade by trade when positions move together. Correlation measures how closely two markets move in relation to each other, and it determines whether several positions are several risks or one large one.

Hidden concentration

• Index futures: ES and NQ are both US equity index futures and often move strongly together. A long in each can behave much like one larger long.
• Currency pairs share legs: EURUSD and GBPUSD both have the US dollar as the quote currency. Buying both is, in large part, one bet against the dollar.
• Related commodities and currencies: some currencies are linked to the commodities their economies export, which can tie positions together in less obvious ways.

Correlation is not stable

Correlations change over time, and they often rise sharply in periods of stress, exactly when diversification is most needed. A portfolio that looks diversified in calm markets can behave like a single position in a sell-off.

Thinking in net exposure

Professional risk managers look at net exposure to underlying drivers, such as the US dollar, US equities or energy prices, not just at the number of open positions. Grouping positions by what actually drives them gives a far more honest picture of total risk.

Educational content only. Not financial advice.