Crypto Correlation Coefficient Strategy
The world of digital currencies, which started with the introduction of Bitcoin, is now flooded with more than a thousand different cryptocurrencies. While the base of all these currencies is blockchain technology, some have been introduced to fund special projects or achieve special goals. However, one thing you will notice about the movement in the values of cryptocurrencies is that a large number of them are related to each other and move in tandem. One can also find several cryptos that share a negative relation with Bitcoin or other cryptos. This correlation between various cryptos needs to be taken note of while developing a strategy for investing in digital currencies.
An analysis of movements of various cryptocurrencies has revealed that most cryptos are dependent on each other when they perform badly, but relatively independent when they do well. So, they are likely to crash at the same time, while increasing independently. Let’s see how a correlation coefficient can be used to develop a crypto trading strategy.
Finding the Correlation between Various Cryptos
The Pearson Correlation Coefficient is a very useful measure of finding out the correlation between two currencies by analyzing their price charts over a specific period of time. The value of the correlation coefficient ranges between -1 and +1. Now let’s see what the various values of this correlation coefficient mean:
- For instance, if the correlation coefficient between Bitcoin and another crypto is 1, it means the two currencies are perfectly correlated and will move in the same direction all the time. This is called a perfectly positive correlation.
- Now, a correlation coefficient of -1 means the two currency pairs will always move in the opposite direction to each other and are perfectly negative correlated.
- A coefficient correlation of 0 means the two currencies are not related to each other and neither are their movements.
Using the Correlation Coefficient for Making Investment Decisions
So, how is this information about the relationship between two currencies useful?
- First and foremost, investors can chalk out a strategy where they do not invest in two different coins that are negatively correlated, since the benefits from one are cancelled out by the losses on the other. Thus, an investor can plan out the amount of investments to be made accordingly.
- Again, if an investor’s aim is to hedge a certain investment, a crypto that moves in the opposite direction of the original investment can be made. This will allow the investor to make up for any losses in case the first crypto loses value.
- Another way in which the correlation coefficient ratio can be used for developing an investment strategy is to diversify the portfolio. Instead of investing in a single crypto, investors can opt to invest in two different currencies that have a high level of positive correlation, say 0.7. This will allow investors to diversify their portfolio without changing the momentum of their investments.
Although the crypto correlation coefficient strategy can be highly useful, one needs to remember that the level of correlation between two cryptos may change over time. One factor that can erode correlation between two cryptos is when investors sell off their main holding, generally Bitcoin, to buy another smaller coin that they believe can climb faster when the overall crypto market is growing.
Investors also need to remember that it is very rare or uncommon to find a perfect correlation between two digital currencies. So, it is always a good idea to use the correlation coefficient along with other research about the crypto to formulate an investment strategy.
Using the Spearman Coefficient
Another option while developing an investment strategy is to use the Spearman correlation coefficient, which does away with the weakness of the Pearson coefficient. The latter assumes that the relationships between two variables is linear. In case of nonlinear yet meaningful relationships, the Spearman correlation coefficient is more appropriate, since it takes a ranking of all the data points in the sample and runs the Pearson correlation on the new rankings data. It compares the two variables based on how their rankings move together. Now, a Spearman coefficient will find the correlation between a perfect exponential relationship as 1 while Pearson would say it is positive but not perfectly correlated.
So, while developing a correlation coefficient strategy for crypto investments, one needs to check whether the relationship is linear or non linear and choose the Pearson or Spearman coefficient accordingly.
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