How to use crypto correlation for better risk management

Key takeaways

Crypto correlation measures the relationship of market price movements between cryptocurrencies and traditional finance assets.
A coefficient number ranging from +1.0 (positive correlation) to -1.0 (negative correlation) is used to give insight into risk management with crypto correlation.
Investors use crypto market correlation strategies to hedge against market volatiles, building a portfolio of assets with varying degrees of correlation to crypto price fluctuations.
Improving risk management with crypto correlation can be done using helpful tools and platforms such as Blockchain Center, DefiLlama and Coin Metrics.

As a seasoned investor with years of experience under my belt, I can’t stress enough the importance of using correlation to manage risks in crypto trading. I remember back in the day when I was just starting out, I made the rookie mistake of over-relying on historical data and ignoring market conditions. I thought I had a foolproof strategy, but then came the infamous market crash of 2018 that wiped out my entire portfolio!

Navigating the risks associated with cryptocurrency investments can be challenging due to the unpredictable nature of the market. To minimize exposure to extreme market swings, it’s essential to construct a diversified investment portfolio that includes a mix of different digital assets, as well as conventional stocks, bonds, and commodities. This approach helps maintain balance in your investments.

By examining the relationship between different cryptocurrencies within your investment portfolio, you can obtain a transparent view of their interplay. This knowledge empowers you to refine your risk management strategy, ultimately striving for a well-rounded and resilient portfolio.

What is crypto correlation?

In simpler terms, crypto correlation refers to how closely the price changes of cryptocurrencies relate to traditional financial assets like stocks or bonds. The mathematical representation for this relationship is known as the correlation coefficient, which ranges between -1.0 and 1.0. A value closer to 1.0 indicates a strong positive correlation, meaning that when one asset increases in value, so does the other. Conversely, a value close to -1.0 suggests a strong negative correlation, where an increase in one asset’s value is accompanied by a decrease in the other’s value. A value near 0 implies no significant relationship between the two assets’ price movements.

Positive correlation: It happens when both assets move in the same direction. It is anything with a coefficient exceeding 0, with a perfect correlation being +1.0, when the two asset types move in the exact same trajectory.
Negative correlation: It occurs when assets move in the opposite direction to each other. As the value of one increases, the other drops in value. The negative is a coefficient of less than 0, with -1.0 when the assets move in value the same amount but in the opposite direction.
No correlation: It happens when the price movements of one asset are completely independent of the other. In this scenario, there is no discernible relationship between the two assets, either positively or negatively. A correlation coefficient of 0 signifies that the price changes of one asset do not influence or align with those of the other in any consistent way.

The correlation coefficient (denoted as r) is commonly calculated using the Pearson method, which measures the strength and direction of a linear relationship between two variables. Here is the formula to calculate it:

On the other hand, there are additional techniques available, including Spearman’s rank correlation and Kendall’s Tau. These techniques are particularly useful when dealing with non-parametric data and monotonic relationships. By employing these alternatives, you can gain significant insights based on the specific characteristics of the data under examination.

Understanding the evolving relationship between Bitcoin and gold

For an investor, it could be beneficial to understand the relationship between Bitcoin (BTC) and gold. Typically, gold is perceived as a safe haven, with its value increasing when more risky stocks decrease in worth.

This graph demonstrates the 30-day moving correlation between Bitcoin (BTC) and gold, spanning from 2017 up until the end of 2024. It displays the way their price fluctuations have interconnected throughout this period.

Historical trends observed

In October 2018, the correlation reached a deep negative value (-0.58), indicating that when gold rose, Bitcoin tended to fall, and vice versa.
The correlation fluctuated between positive and negative over the years, reflecting shifting investor sentiment and market dynamics.
By Nov. 13, 2024, the correlation stood at -0.36, suggesting a moderate tendency for Bitcoin and gold to move in opposite directions, though not perfectly so.

How gold and Bitcoin reacted to US election results

2024’s U.S. presidential election has noticeably influenced financial trends, as the value of gold dropped more than 4% following Donald Trump’s win, reaching $2,618 per ounce. This surge in market confidence pushed up U.S. stock indexes, diminishing gold’s status as a secure investment option.

The strong U.S. dollar, fueled by anticipated trade tariffs and decreased interest rate reductions, increased the cost of gold for foreign investors, exacerbating its price drop. At the same time, Bitcoin’s relatively weak negative association with gold (-0.36) highlights their separate investor behaviors, as political changes influence inflation predictions and monetary policy.

In my analysis, while gold continues to hold its image as a safe haven, its instant appeal seems to have waned within the unpredictable economic climate following the elections.

Why crypto correlation matters for risk management

Correlation is a key metric for an investor’s crypto portfolio risk management and helps to understand how to reduce the overall risk position. It can be used to give perspective on the nature of markets and how they react to one another when crafting your crypto portfolio diversification strategies.

Cryptocurrency trading involves significant risks due to the market’s frequent fluctuations. Essentially, most cryptos are high-risk assets because their value can rise or fall sharply within hours or days. When prices are high, investors often choose to sell to secure their gains, thereby lowering their investment amount and vulnerability to future price swings.

Traders could consider investing in assets that are more stable or have a counteracting relationship with cryptocurrencies after a decline. This way, when the market takes a downturn, their investment portfolio is safeguarded, or even gains advantage, thanks to this risk-mitigating approach.

As an analyst, I often seek out investment opportunities that have a positive correlation with the crypto market. This strategy allows me to predict how the market will respond to economic events more effectively. Moreover, by investing in exchange-traded funds (ETFs) that focus on blockchain and cryptocurrency, I can indirectly tap into the crypto market without having to directly own and manage cryptocurrencies myself.

Diversify your crypto portfolio

A crucial aspect in handling investment risks is diversification. This strategy allows you to construct a portfolio that disperses risk across various assets. In other words, the success of your investments isn’t tied to just one or a few types of assets. As a result, you can minimize losses when a specific asset class experiences a decline or potentially earn more when they perform well.

Gaining insights into the relationship between different assets in trading can help construct a balanced investment portfolio. Lacking this understanding could potentially lead to having investments that are not adequately diverse.

If you own cryptocurrencies but aim for a diversified investment mix, it would be beneficial to incorporate assets that don’t move in tandem with cryptos. This way, when the crypto market experiences downturns, other segments of your investments can remain secure.

Have you found out that lately, there’s a growing relationship between the performance of cryptocurrencies and the S&P 500? It has been observed that this bond has strengthened from 0.54 to 0.80, suggesting that the movements in the crypto market are mirroring those of the stock market.

How to measure crypto correlation

Determining the correlation among cryptocurrencies involves intricate computations. Luckily, a variety of tools and platforms can assist you in carrying out these mathematical operations.

Below are the steps to using correlation in crypto trading:

Select your data source from trusted financial data providers, such as CoinMarketCap, CoinGecko and Bloomberg.
Download or record historical prices for the assets you want to analyze.
Choose your correlation method; the common ones are Pearson, Spearman or Kendall.
Use data analysis tools like Excel, Google Sheets, Python or R to understand your correlation data and build graphs to visualize insights.

Tools for analyzing crypto correlation

Multiple businesses offer ready-made cryptocurrency trading advice and resources that utilize correlation. These solutions help bypass the need for intricate data analysis, instead providing you with immediate trading suggestions and real-time insights.

BlockchainCenter provides a dynamic tool for comparing the leading cryptocurrencies, gold, and the S&P 500. This tool is designed to help users make more informed decisions when it comes to diversifying their investments by considering the relationships between these assets.

With DefiLlama, you can easily obtain the Pearson correlation coefficient for trends between Bitcoin and various altcoins. Additionally, you have the option to customize this analysis using your own specific data.

Coin Metrics offers a sophisticated tool featuring various correlation techniques, as demonstrated in the following image.

Did you realize that Sir Francis Galton was responsible for creating the correlation coefficient back in the 1880s? In his groundbreaking work, he coined the term “co-relation” and defined this measurement as an “index of correlation.

Common mistakes when using correlation in risk management

Using correlation offers useful insight for risk mitigation in crypto investing. However, there are several common mistakes to avoid costly pitfalls. Adding to this, investors might also need to adapt strategies and coefficients based on new market conditions.

Here are the mistakes to avoid in your crypto correlation risk management:

Over-reliance on historical data: Analyzing crypto correlation for trading relies heavily on historical data. History, however, is no guarantee of the future — at best, it echoes. There are myriad factors impacting future asset economics, including regulation changes and macroeconomic trends.
Ignoring market conditions: Event-driven volatility can drastically alter correlations, an ignorance of which leads to unexpected portfolio performance. In addition, periods of market stress can cause correlation changes, which expose a portfolio to higher systematic risk.
Data misinterpretation: Inaccurate calculations or misinterpretations lead to flawed portfolio risk assessment. Making decisions based on misunderstood data creates inefficient asset allocation.

Awareness of these potential dangers empowers investors to make thoughtful choices and handle their investments more skillfully.

2024-12-09 10:37