What is correlation?Correlation

Two stocks that have long moved together drift too far apart: buy the cheap one, sell the expensive one, and wait for them to come back together. It's a bet that the relationship holds.

An airline wants to hedge jet fuel, but there's no good jet fuel futures contract. It has to borrow the closest-priced instrument instead.

Spot and futures don't move in lockstep. How much should you hedge? The optimal ratio depends on correlation and volatility.

A global portfolio is exposed to US stocks, European stocks, the euro and crude oil all at once. Switch on the hedges one by one and watch total risk come apart piece by piece.

The more assets you hold that don't move in perfect sync, the less your portfolio swings. But correlation sets the limit on how far diversification can go.

60% stocks / 40% bonds looks balanced, but stocks are far more volatile, so over 90% of the portfolio's risk actually comes from stocks. Risk parity makes each asset class contribute the same amount of risk.

Risk 1% per trade and hold 8 at once, and that's 8%. If those positions are highly correlated, they'll hit their stops together: diversified on the surface, one big position underneath.