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Making a Bet Against Correlation

Friday, 4 Nov 2011 | 2:35 PM ET
Stock Chart and Dice
Stock Chart and Dice

We’ve been living in a global macro world for quite some time. Stocks seem to move together based on the latest news out of Europe or the Federal Reserve.

Every now and then you’ll hear someone come on CNBC and remark that eventually we’ll see a “stock picker’s market” again, which is to say that stocks will not always be as correlated as they are right now.

How do we know stocks won’t always be so correlated? Well, history tells us that we’re at an extraordinarily high level of correlation, much higher than the historical mean. Odds are that we’ll eventually revert back toward more normal levels of correlation.

For some traders, the end of correlation will be a signal to start hunting for individual stocks to buy or short. But Jared Woodard of Condor Options believes that’s waiting too long. He has devised a trade intended to basically short correlation. That is, to bet on the decline of correlation.

Here’s how it works. You find a stock that is usually uncorrelated to the movement of the S&P 500, but has been recently moving with the broader market. He would then buy a straddle on the stock and sell a straddle on the S&P 500.

Here’s how Woodard describes the possible outcomes:

A best-case scenario would be one in which the index doesn't move very much but the individual stock moves a lot, generating time-decay gains for the short straddle and long-gamma gains for the long straddle. The worst case would be that the opposite happens (the index jumps in one direction and the stock goes nowhere), but that's not likely to happen since we will be trading an issue that has already demonstrated a recent affinity for index-like behavior. If correlations stay high and both assets move together, our expected loss is nominal.

There are a number of stocks the would meet the criterion—low historical correlation, high recent correlation—for this trade.

Woodard singles out Occidental Petroleum, an energy company which “has no business tracking the broad market index under normal circumstance, but has recently been bounding along with the warp and weft of the European crisis."

Should be interesting to see how this plays out.

Questions? Comments? Email us atNetNet@cnbc.com

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