The correlation between two stocks entered a downtrend on September 14 at 16:00 ET at the +0.53 level. The trend is still ongoing (23 candles, 92 trading hours). It has declined from the +0.53 level to the +0.244 level. AAPL rose 2.72%, MSFT fell 2.17%.
In my correlation calculation, I use both a different methodology and a trend calculation. In addition, I also have data specific to the individual stocks. According to this, in the past (in the last 10 instances) when these two stocks entered a downtrend at this correlation level, they lasted a median of 18 candles (it is currently continuing beyond the median candle duration and has bottomed out). They diverged. Hedge strategies came to the fore.
My game plan: The correlation between them is in a downtrend and it bottomed out at the last 4-hour candle close (22 Sep 12:00 ET). To price in this divergence, I will structure an AAPL call option buy, Microsoft short trade plan. My profit/loss amount and its shape vary according to the course of the correlation between them.
a) In the best-case scenario, if the correlation between them continues to decline; AAPL rises, MSFT falls, then profit will be made both from the call option and from the short position.
b) If AAPL's rise continues the call option profits, if MSFT moves sideways; it will have been a slightly loss-making hedge position.
c) If the correlation between AAPL-MSFT shifts into an uptrend; if AAPL and MSFT rise together the call profits, the short loses. Since the weight will be on the call option, my hedge will have shaved off some of the call's profit.
d) If AAPL-MSFT fall together (if the correlation recovers) the MSFT short will tolerate the call's loss to some extent.
e) The worst-case scenario, if the divergence between them continues but AAPL turns to a decline (call loses) MSFT turns to a rise (short loses) but the correlation continues its decline. For this reason the trade will continue for me throughout AAPL's rise and the correlation divergence.
My expectation is that the decline in the correlation regime, the divergence between the two stocks, continues and that the rise occurs on the AAPL side. Especially if AAPL sustains above $340, an AAPL Oct 23 345 call (\~0.48delta, \~$8.65, IV \~24% — low for AAPL) suits me, delta-matched against a short in MSFT. A pullback in MSFT from the 495–505 zone gets priced in on the short leg.
It’s a slightly belated trading plan, but as you can see in the chart, the fluctuations in the correlation slowed me down, and I want to give it a try. Does AAPL sustain above 340, or does the correlation snap back first?
*Methodology: Four-hour candle closes are used while the markets for both instruments are open (08:00, 12:00, 16:00, 20:00 ET). The correlation coefficient is a composite score derived not only from the Pearson method but also from Pearson, Spearman, and EWMA calculations.*
