Updated on March 8, 2023
The term covariance in technical analysis is a statistical measure of the relationship between two variables (for example, the prices of two stocks or securities). Covariance is used to determine whether the movements of two variables are positively or negatively correlated and their interpretation. A positive covariance signifies that the two variables move in the same direction. On the other hand, a negative covariance indicates that the two variables move in opposite directions.
How is Covariance used?
Covariance can be used to assess the risk and return of a portfolio of securities. By determining the covariance between different stocks, traders can assess the level of diversification in their portfolio and identify potential risks. If two stocks in a portfolio have a high positive covariance, this means that they are likely to move in the same direction and will be exposed to similar risks. Similarly, when two stocks in a portfolio have a low or negative covariance, it implies that they are likely to move in opposite directions and will provide some level of diversification.