Why are stock return correlations different from stock price correlations?

Question

Hi!

I've seen many times that the correlations of daily returns of some stocks can be negative, while the correlations of their prices strongly positivie (like >0.9)..

How is this possible? What is the explanation for this?

Thanks,
W

Answer 1

think it out ...

suppose yesterday's closing price was 40 ... that's likely a pretty good predictor for today's and tomorrow's closing price, isn't it? [Most daily price movements are small.]

but the daily return is (C0 - C1) / C1 {daily price change divided by prior close} ... this would show positive correlation over the measurement period only if the stock was continuously in a strong trend {either up or down}. Negative correlation here means that the size and direction of yesterday's percentage price movement is a poor predictor of today's price movement -- at least as your source measured the predictive value and over the time frame used.

Btw, there's more, much more, on the subject. You might begin by wondering why different stocks show different correlation values on daily returns data.


GL