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Eqonomics

The Correlations in Crypto

May 13, 2022

Adam Wise

The Correlations in Crypto

As markets behave badly, we can observe how crypto correlations have developed. In this Eqonomics, we explore the timing and magnitude of the correlation between BTC & ETH.

All data in this blog is sourced from Messari and as of 12 May 2022, unless the period is otherwise stated.

The Price Picture

It has been a tough year so far, with BTC and ETH down over 40% at writing. Risk assets are down across the board as inflationary pressures force the hand of Central Banks to increase rates and tighten liquidity.

Chart 1: 2022 Cumulative Performance

Looking at the performance on Chart 1, the correlation is visually clear and is backed up statistically: 0.92 this calendar year. A value of 1 would imply a perfect positive correlation between the two.

Chart 2: 2022 Daily Performance of BTC/USD vs. ETH/USD

Similarly, plotting daily returns against one another, we see a gradient close to 1 with no outlying data points.

The Correlation Coefficient

Correlation between sets of data measures how they move in relation to one another. We employ a popular method for our calculations: Pearson’s. The result (r) will be a coefficient value between -1 and +1.

A positive value, r > 0, means the two variables move in tandem, and the closer to 1, the more this is true. A value of r < 0 signifies the variables move in opposite directions. A value of -1 would mean they are perfectly negatively correlated. When one increases, the other decreases on every observation. Any value close to zero indicates no correlation.

Correlation is calculated using rolling 3-day natural log returns

Historical Examples

If we enlarge the period to 5 years, we still observe a positive correlation, but it is weaker at 0.73.

A single coefficient omits important information: when does BTC & ETH correlation strengthen or weaken. For a more granular approach, we can use rolling correlation windows.

Chart 3: 1-Month Rolling Correlation of BTC vs. ETH

Now let’s look at recent examples of significant drawdowns in crypto markets to see how correlation evolved.

Chart 4: Q1 2020 Returns vs. Correlation

As the potential implications of COVID hit the market, risk assets sold off aggressively, and correlation rose to nearly one during the latter half of March 2020. 

Chart 5: H1 2021 Returns vs. Correlation

Markets were flooded with liquidity as Central Banks attempted to fight off any restriction-led recession. As one of the chief benefactors, crypto saw values overextend and long leverage build up on exchanges. This ultimately led to the “Saturday Night Live top” and reversal in May.

Conclusion

Unfortunately, and perhaps unsurprisingly, correlation tends to increase during market dislocations – such as the one experienced this week. Any diversification can be rendered obsolete at the time when investors need it the most.

However, one possible benefit of correlation increasing during downturns: You may be able to partially hedge your portfolio with a single ‘risk-off’ instrument. Examples could be short futures or long put options positions on a chosen crypto. The selection of crypto underlying will determine the magnitude of how well it hedges, so it needs to be sized appropriately.

The correlation merely accounts for the direction and is not guaranteed. Something for you to explore further, should you wish.

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