Home/Blogs/What Is Covariance How To Estimate Covariance Of Any Stock

What Is Covariance How To Estimate Covariance Of Any Stock

25 Sep 2023

Introduction

Covariance is a statistical concept that allows investors to determine the direct relationship between returns of two different investments. The formula of covariance helps you to identify the future trends and predict how stocks are going to perform when compared with one
another. Positive covariance indicates two stocks that move in the same upward direction together. While negative covariance refers to the downward movement of stocks in the opposite directions. Investors usually choose to negative covariant stock, as this allows them to add diversity to their portfolio. If one stock falls, the other rise, balancing the overall portfolio.

How can you calculate the covariance of stocks?

Let's understand how you can calculate covariance of stocks based on which you can make the right investing decision.

Open Your free Demat Account in just 5 minutes!

Formula used in calculation of covariance

Formula of covariance for variable X and Y = Cov(X, Y) = Σ(Xi-μ)(Yj-v)/n
Where,
Xi and Yj = all values of X and Y, respectively
μ and v = average value of X and Y, respectively
n = number of data points
Cov(X, Y) = Covariance of X and Y

What are the steps to calculate covariance?

Let's assume an investor has a portfolio with stock A, but he wants to add stock B to his
portfolio. Before adding any stock, he needs to assess and analyse the ‘directional relationship’,
i.e., covariance between stocks A and stock B.

To calculate the covariance, he must follow these steps:


Step 1: Gather the data of both stocks, including their historical returns. One can find
past returns by taking the stock’s closing price value of each day. Take at least 5 days
past returns to calculate covariance.
Step 2: Now, calculate the average or mean prices of stocks.
Step 3: Find the differences between each data point and the average price of each
stock.
Step 4: Put the values in the covariance formula, and you will get the value.

The stocks will probably move in the same direction if the value is positive. It means that if
stock A gives a high return, stock B will also give a higher return.
 

Conclusion

The covariance tool allows investors to gain insights into the movement of stock prices based on which they add stocks to their portfolios. The finance industry uses covariance to evaluate the risk associated with investments by comparing their movement directions. They see whether the stocks move together in the same direction or opposite, and based on the evaluation, they make investing decisions. Investors use covariance tools to mitigate their portfolio risk by adding negative covariants. If one stock gives less return, the other balances the portfolio by giving a high return.

 

Related Articles: How to Open a Demat Account Without a Broker | Factors to Keep in Mind While Opening a Demat account | Factors to Consider When Opening a Demat Account 

 

Popular Stocks:  HDFC Bank share price | ICICI Bank Share Price | UPL Share Price | Tata Consumer Share Price | Divislab Share Price

Checkout more Blogs

You may also like…

Get Exclusive Updates

Be the first to read our new blogs

Intelligent investment insights delivered to your inbox, for Free, daily!

Open Demat Account
I wish to talk in South Indian language
By proceeding you’re agree to our T&C