V.6:4 (133-134): Correlations: serial and auto by Clifford J. Sherry, Ph.D.

V.6:4 (133-134): Correlations: serial and auto by Clifford J. Sherry, Ph.D.
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Correlations: serial and auto by Clifford J. Sherry, Ph.D.

Suppose you are testing a pricing pattern to see what relationship it has to future price movement. Or, you are testing an indicator's correlations with price movement. In each case, you need a definitive test to tell you if there exists a statistically significant relationship.

Again, much of the early work testing the various forms of the efficient market hypothesis utilized either serial or auto correlation techniques. (See for example, P. Cottner's Random Character of Stock Market Prices, M.I.T. Press, Cambridge, 1964). Unfortunately, correlation techniques may not provide an adequate test of this hypothesis and using these techniques may lead to false conclusions.

If you are to test whether or not relationships exist, it is important for you to understand how correlograms are constructed and what they mean. As an example, the techniques described here will reliably show meaningful correlations, if they exist. I will use a series of artificial "prices" to minimize problems of interpretation.

Beginning with Figure 1, we will construct the "lag-1" serial correlogram by examining sequential pairs of prices. That is, we will compare the action of today's price with that of yesterday'só the price with a one-day lag.

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