I’ve shared many Wheel Strategy tips in these articles in the past for the Wheel Strategy. For example, you should only trade stocks that you really want to own.
I did a video on how to find value stocks versus growth stocks, if you would like to check it out after reading this article, you can check it out HERE.
But today I want to share something that we have talked about in our Mastermind group quite a bit over the past few weeks, and this involves stock correlation.
When trading The Wheel Strategy, the first step is selling puts while collecting premium. Then, after you sell puts, you may or may not get assigned the stock, so you must be willing to own these shares. So it’s important to find the best stocks.
Correlation Between Stocks
One of the stocks that I recently traded was CLF, Cleveland Cliffs. They are in non-energy minerals, so basically steel. Is this a value company? Yes, I believe they are.
When I traded it, I was selling the 20 puts so this had some solid support. We broke below, but we are trading right now (at the time of this writing) at $19.86, so that is okay.
However, when now you run the Wheel Scanner, you might actually see that you have X, U.S. Steel popping up.
U.S. Steel looks very similar to the CLF chart. It’s because they’re both in the same industry. Here’s the interesting thing.
If you look at CLF and then we overlay the chart of U.S. Steel in the above example, we see that these two stocks are highly correlated. The orange line is the chart for US Steel and the regular one is the chart for CLF.
We have a very high correlation here. This is one of the things that you might not know, so you can use these overlay charts. But then, as you zoom out, the whole thing changes, right?
If we zoom out, we can see that a while back they weren’t as strongly correlated as they are right now. The correlation seems to get stronger as we zoom in.
Now here is something that we just released in PowerX Optimizer, and this is especially important when you’re trading the Option Wheel strategy. This is an asset correlation tool.
Asset Correlation Tool
This means, when you enter two or more tickers, for example, CLF and X, you can see how correlated these two are.
And if you look back just over the last three months, we see that there’s a super high correlation. What does this mean and how do you use it in your trading, especially with The Wheel Strategy?
We see the correlation is 0.88. This means, if there’s a correlation of one, they are highly correlated, and basically, they’re moving exactly the same.
So if you would compare CLF with CLF it would be a one because they move exactly the same. In our CLF and X example, a correlation of 0.88 means that they are very highly correlated.
Stock Correlation Ranges
Now, this correlation goes from -1 to 1, so if you see something with a negative number, it means that they are not correlated at all. They’re moving in different directions.
Let’s compare some oil stocks to CLF and see if they’re moving in different directions.
No, they’re not, but you see, 0.16 is not a very strong correlation. If you have a correlation of zero, it basically means it’s neutral.
They’re not correlated. If you have negative numbers, it means that they’re inversely correlated.
Example of Inverse Correlations
Let me just give you another example here.
Let’s look at TQQQ and SQQQ. These are two ETFs. One of them, as you can see, is an inverse ETF. So this is a negative of one.
This means here that there is basically an inverse correlation. Let me show this to you at the chart.
We see that they are moving exactly in opposite directions. As TQQQ goes lower, SQQQ goes higher. They’re directly inverse correlated and this is why we have here a correlation of -1.
How To Use This With The Wheel Strategy
Why is this important when you are trading The Wheel? Let me just show you a few of the positions that I’m in right now (at the time of this writing) and you can see how I use it for my options trading.
A few stocks that I own are ADI, another one is CLF, and then DHI.
If you look over the last three months, we see that DHI is somewhat correlated to ADI.
It’s a little bit surprising because ADI is in technology and semiconductors, while DHI is home builders here. I’m very surprised that they are correlated.
This is why it is so important to have this correlation tool.
What Stock Correlation Is Ideal For the Wheel Options Strategy?
You want to see a stock correlation that is less than 0.5. Anything above 0.5 means that there’s a strong correlation and is not recommended for Wheel trades.
Anything above 0.7 means that there’s a very strongly correlation. I would strongly discourage you from taking trades of stocks that are highly correlated.
For example, this is where I said if we have a very high correlation, this is why it is dark orange, you should not trade this because you already have a stock that is very similar in your portfolio.
Wheel Scanner Example
Let’s take a look and see what is coming up on The Wheel scanner. One stock coming up is DKS, Dick’s Sporting Goods.
First of all, we want to see if Dick’s Sporting Goods is a value stock, so we click on the megaphone icon.
We take a look at the revenue and the profits, and we want to see that we have solid revenue numbers here over the last five years.
And we do, we have solid revenue numbers. We have profits. They’re in the retail business, so the profits are rather slim.
We can take a look at quarterly, and you also see very solid numbers here. This is definitely something that I would consider a value stock.
Another hint is that they are paying a dividend of 1.6% and value stocks are usually the ones that are paying dividends. Growth stocks are not usually paying out, they keep all the money to keep growing.
And the PE ratio here is also rather low at 8.45.
Compare this to something like Tesla which has a PE ratio of 188.
But back to DKS, this is definitely a value stock. I did a whole video on finding value stocks vs finding growth stocks, and you can check it out HERE.
Now I want to see if there is some solid support. We have the lowest close indicator here, the blue line, which basically tells us what the lowest close was over the past eight weeks.
We see that price is moving around 100 and 150. Right now we could sell at a strike price of 102. By doing this, by selling a strike price of 102, we would get 30 percent annualized.
Comparing Potential Stocks To Stocks You Already Own
Now we want to compare DKS to the stocks that we already have in the portfolio. Is there a high correlation?
No, everything is green. DKS compared to ADI, CLF and DHI have a correlation of 0.38, 0.20, and 0.33, respectively.
Since these numbers are below 0.5, it means there’s not a whole lot of correlation.
Let’s bring up DKS here on the charts, and overlay it with ADI. The orange line is ADI, and we see there’s not really a lot of correlation going on.
This is where we can make sure. I like to look back over the last three months, but we can also see over the last six months.
Over the last six months, all of the stocks that I would consider having here in my portfolio are not very correlated.
Another stock we can take a look at is CWH, Camping World.
Let’s say that you’re interested in Camping World, but we would first see how it fits in our portfolio.
We see that Camping World, the same as DKS, is not very correlated. But what if we would trade Camping World and DKS? How correlated will they be since they are similar companies?
As you can see, they are not very correlated, and I’m a little surprised by this.
I thought that there was a stronger correlation between Camping World and Dick’s Sporting Goods because, in the broad sense, they’re similar companies.
Dick’s Sporting Goods sells fishing gear, tents, and hunting gear. And then you have Camping World, campers, and RVs.
So I would have thought that there is a higher correlation, but apparently, there is not, which is good if you want to own both.
That’s why I thought I’d share these Wheel Strategy tips with you because I believe it is important that you know this when trading anything.
I don’t think it is that important for the PowerX Strategy, but definitely for The Wheel Strategy, or if you have a portfolio.
With this correlation tool here, you can compare up to 10 different symbols trading on the stock market.
Comparing Similar Companies
Let’s say that you have Tesla, Apple, and Facebook in your portfolio.
This is where you see, if this were your portfolio, that there is actually a pretty strong correlation between ADI, Tesla, and Apple.
With Apple, it’s 0.62. This is why I think it’s just interesting to see that there’s a correlation between Tesla and Apple of 0.62.
Again, I would be more concerned if it is more towards 0.7. This is where I said earlier, you have the different orange shades. As soon as we pop above 0.7 it will be very bright orange.
Anything that is just dark green or light green, you know that you’re very well diversified. This is what this is all about. It just helps you to see how diversified are you.
Not just by you guessing, but looking back over the last three months, six months, nine months, or if you want you can look back over the last two years if there was any correlation.
I personally think that the last three months or six months are more important here than overall the last two or three years, right? You want to just see what is happening here right now.
But I just wanted to share this stock correlation with you, so you can incorporate it into the Wheel Options strategy.
If you are a serious options trader and would like to learn more about the two trading strategies that I trade, I suggest picking up a copy of my books, which cover both of these options trading strategies in detail.