In my last post I talked about a program that would find a stock that would lead or lag a stock you selected. Lets take $AAPL for example. Below are the top 5 positive and negatively related intra-day stocks for Apple Computers calculated on 9/18/2010 with 5 minute bars.
However, there is a special attribute to this information. $AAPL time1 is not correlated with $DTV time1 then squared (that is how you calculate R^2. Read about it here). It is correlated with time3 of $DTV. The illistration below should help. (Please note the prices below are for examples purposes only)
On the left is the traditional stock by stock correlation. On the right is a leaders/laggers correlation. What this does is allow you to have an understanding of what $DTV will do with greater confidence than if it was correlated with $AAPL time1. The reason is this: When a stock is trending that trend can change suddenly and if you’re pairs trading or using correlated stocks it will change immediately with it. When you lead/lag the R^2 tells you that while $APPL is rising 10 mins later $DTV should be rising as well (within a degree of confidence of course). Also if $APPL is reaching a bottom $DTV should reach a bottom 10 minutes later. The chart below should illustrate this concept
As you can see as $AAPL hits a bottom at $243.62 at 11:45am $DTV hits it’s bottom at 37.70 11 minutes later at 11:56. This is the power of lead/lag. There are many strategies one can implement knowing this information.
Hope you enjoyed this post