Correlation is a popular concept in trading and investing. It is popularly used by market participants through the arbitrage strategy as a way of reducing risks. It is also used by traders with a pair trading approach. This article will look at what correlation is and how you can apply it in cryptocurrency trading.
What are correlations?
Correction is the mathematical study of relations between two or more things. It is a concept that is used in multiple fields like finance and technology. In finance, many investors have embraced it as part of the so-called arbitrage approach. Indeed, according to Barclay Hedge, arbitrage hedge funds have more than $83 billion in assets under management (AUM).
There are several approaches to calculating correlations across assets. The easiest one is to just look at charts and see whether there is any relationship between two or more assets. For example, the chart below shows that the GBP/CAD and EUR/CAD pairs move in a similar direction because they have the same counter-currency.
GBP/CAD and EUR/CAD
The second approach is more complicated because it involves doing a mathematical calculation. The easiest way to do this is to download two assets, export them to Microsoft Excel or Google Sheets, and then run a correlation calculation.
The correlation coefficient of the two assets will always range between -1 and +1. In this case, a correlation of or close to -1 means that the two assets have an inverse relationship. This means that the two assets typically move in the opposite direction.
On the other hand, a correlation of or close to 1 means that the assets have a close relationship and that their prices tend to move in the same direction. Finally, a correlation coefficient of zero means that the two assets have no relationship.
Correlations in cryptocurrencies
Correlations happen across different asset classes. Assets in the same sector can have a close correlation. For example, indices like the Dow Jones and S&P 500 tend to move in the same direction. Similarly, assets of different classes like currencies and commodities can also have a relationship.
Cryptocurrencies have a significant degree of correlation among themselves. Indeed, in most cases, the prices of altcoins like Cardano and Polkadot depend on the overall movement of Bitcoin. Their prices tend to fall when Bitcoin declines and vice versa.
Correlations in cryptocurrency happen because of the nature of the industry. For one, most people who trade in digital currencies are retail traders. This is unlike in other industries like stocks that are mostly dominated by institutional investors.
Therefore, since cryptocurrencies are a relatively new industry, many people trading them don’t understand what they do. Indeed, studies show that many crypto traders do so without knowing what they are trading in. For example, very few traders know what Stellar Lumens, Filecoin, and IOTA are and what they do.
A closer look at the performance of cryptocurrencies shows that they move in the same direction as Bitcoin. For example, between March 2020 and May 2021, the price of Bitcoin rallied after the Federal Reserve moved to cut interest rates and boost quantitative easing. As the BTC price rallied, other altcoins like Cardano, Binance Coin, and Ethereum rallied. The chart below shows the close correlation between Bitcoin, Ether, and Polkadot.
Bitcoin vs Ether, and Polkadot
Another reason that explains crypto correlations is their pricing. Many traders prefer using Bitcoin and Ether as proxies for smaller coins.
The second chart above shows that cryptocurrencies like Bitcoin, Ether, Litecoin, Ripple, and Cardano have a correlation of almost 100%.
How to use crypto correlations in trading
Crypto correlations can be a useful tool in trading and investing. For one, it will help you avoid the common mistake of creating a diversified crypto portfolio. While buying and holding several cryptocurrencies can be a good thing, it exposes you to risk when their prices drop. Still, using correlations can show you currencies that don’t have a close relationship.
Fortunately, it is possible to day trade cryptocurrencies that have a close correlation and those that have an inverse relationship.
A good example of this is taking two coins like Polygon and Cardano. At the time of writing, the two coins are trading at $1.0 and $1.34, respectively. While Cardano and Polygon are different coins, their prices tend to move in the same direction, as shown below.
Cardano vs Polkadot
The first step in this example is to do a technical analysis to find out the most likely direction the two currencies will go. If you believe that the two coins will rise, you can buy Cardano and then short Polygon. In this case, if you are correct, your trade on Cardano will be profitable, while that of Polygon will make a loss.
Therefore, your total profit in this situation will be the difference between the profit and loss. This is known as a spread. You can also find other cryptocurrencies that have a similar price, do a correlation calculation, and then open a similar trade.
Correlation is a trading concept that is used widely by professional traders across different asset classes. It is a useful strategy that can make you make money while reducing risks. It is particularly useful in crypto trading because many cryptocurrencies have a close correlation with one another.