Nifty Benchmark Index (NIFTY 50) and BANK NIFTY exercise a strong positive correlation for many years now, which means a statistical relationship in which both the indexes generally move in the same direction together.
And within, BANK NIFTY
It’s clearly visible from the above chart that the share price of SBI and the share price of ICICI were travelling in same motion for many years.
How to make use of this pattern for trading?
Co-relation Strategy: As mentioned above, both the stocks move in tandem and are likely to do so in the future as well. In such a case, if one identifies a long/short position in one of the stock, then same can be exercised on the other stock as well.
By doing so, one can generate maximum returns at the cost of single analysis but let’s not forget that higher the positive co-relation, diversification benefits are minimal and it could turn out to be a fatal error, if your analysis proved to be wrong – Trading with SL can minimize the risk considerably.
Co-Integration Strategy: This strategy banks on the belief that the positive correlation minimizes the standard deviation between these stocks and if the stock tries to move away from each other beyond the average standard deviation level, it tends to restore back to the acceptable standard deviation level.
By using this strategy, one can go long in the lagging stock and the leading stock can be shorted when the momentum is upside and vice-versa.
Even this technique has its own shortcomings like both the stock continue to move in opposite direction for prolonged period and one should exercise adequate risk control measure to make use of this technique for one’s advantage.