Hello,
I have a very basic questions about correlation between time series:
1) it is more convenient to look at the absolute value of the prices of two stocks to identify correlation or it is more appropriate to look at the correlation of returns?
2) in my intuition if the prices are correlated also the returns are, is that true? if not could you provide me an example?
Thanks in advance
Jack
Generally look at the correlation between log returns and not prices. Price correlations are generally not meaningful and often can be very misleading. Google 'price vs return correlation' or something similar to find a number of articles on this.
Attached is a notebook which generates two random sets of stock prices. The last cell of the notebook compares the correlation between the prices and between the log returns. The price correlation varies widely and is often quite high (even though these are just random walks). The log return correlation is always low (which one would expect since they are random).
Though it may seem 'counterintuitive', prices are often highly correlated while returns are not. This misleading price correlation is a by-product of the random-walk nature of stocks.
Play with the notebook to get some insight into this. Good luck!
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