Measure the linear relationship between two continuous variables, a cornerstone of portfolio diversification and pairs trading.
Pearson Correlation measures how well two assets move in relation to each other. It gives a value between -1 (perfectly opposite movement) and +1 (perfectly identical movement). A value of 0 means no linear relationship. Think of it as a "dance partner" score for stocks.
Crucial for diversification—combining negatively correlated assets can reduce overall portfolio risk.
A scatter plot is the best way to visualize the relationship between two variables. The tighter the points are to forming a straight line, the stronger the linear correlation.
Example: We plot the daily returns of two assets. By adjusting the slider, you can change the underlying correlation between their returns and see how it affects the scatter plot. This is fundamental to pairs trading, where you look for highly correlated assets whose prices have temporarily diverged.