So You Want to Trade Crypto - Exploiting Cryptocurrency Correlation (Part 5)

There is correlation within any sector or asset class, however there are particularly interesting patterns in Cryptocurrency due to the new and speculative nature of the market, along with its historical pairs structure.

Weakness and Strength

 (Raw USD pairs from  coinmarketcap.com , raw BTC pairs from  poloniex.com )

(Raw USD pairs from coinmarketcap.com, raw BTC pairs from poloniex.com)

Historically, the Cryptocurrency space has been dominated and led by Bitcoin, with Bitcoin’s 80% — 90% of total market cap only starting to be challenged in the last couple of years, as covered in “Market Cap Distribution and Rise of Altcoins”. This huge shift in capital distribution caused a bloom in many Altcoins during the major bull run of 2017.

However, despite this redistribution of power in the market, a correlation between different altcoins and Bitcoin stayed strong throughout 2017, suggesting that the market is still centering around Bitcoin both as an indicator of general sentiment and health and, as a safe haven asset.

During the bulk of the bull run, correlation of USD pairs stayed high, with the notable exception of periods prior to Bitcoin pullbacks, such as the dips from $3k and $5k. This seems to form a bit of a leading indicator (albeit a very noisy one), as a divergence in altcoin movement appears to precede a local top and a pullback.

Correlation and investor sentiment

The BTC pairs also tell an interesting tale, moving into negative correlation as the Bitcoin trend weakened before bouncing back once a bottom had been reached.

This view of combined market correlation can also give clues to the sentiment of investors. During bull markets, projects have a high-value premium based on the expectation of future success, meaning that while correlation stays generally positive, the price movement of projects will shift around based on their own news and merits — lowering overall correlation.

However, if we look to 2018 and the bearish trend, we see a very different pattern as fear enters the market. Correlation tends towards 1.0 in a bear market, as sell-offs are sharp across the board due to the cycle of panic. Individual projects are no longer values on their own merits, instead being sold off at whatever price they’ll fetch as the market falls in unison.

This fear can be seen clearly as Bitcoin’s first sell-off from $19.6k to $6k takes effect, followed by a very slight regaining of hope after the bounce (drop in correlation) before tending back towards 1.0 as we moved for a retest of $6k.

ALT/BTC pairs and hedging

Historically, most Cryptocurrency trading was done with Bitcoin as the base pair, and even now we still see $100Ms daily through Bitcoin pairs. Back in the days where both regulation and market volume was limited, this made a lot of sense. A Crypto-Crypto exchange didn’t need to deal with the hassle of accepting and storing fiat currencies, nor the regulatory issues of handling money.

This had the effect of tying the USD value of altcoins closer to the shifts of Bitcoin, which is still a factor today (although to a lesser extent). This, along with the psychology of fear during a bear market, has lead to the levels of correlation we see in the USD pairs during large pullbacks.

In theory, this makes ALT/BTC pairs extremely useful for trading: during a bull market you’re betting that your chosen coin does better than Bitcoin on its technical merits; during a bear market you expect the ratio to stay relatively level as your coin maintains a correlation near to 1.0 against BTC/USD.

However, in reality we also start to see correlations between the ALT/BTC pairs and Bitcoin also rising during major downturns, suggesting that Bitcoin is used as a safe haven asset to hedge against pullbacks, as people rotate out of higher risk and reward altcoins.

This causes issues in the assumption of a hedged market exposure from trading Bitcoin pairs during a pullback. This does, however, provide yet more signals as to market sentiment. Since you will often see sharp dips in BTC/USD being mirror across ALT/BTC pairs, a deviation from this trend is a helpful indicator of market strength and bullish sentiment.

Trading the correlation

An understanding how different Cryptocurrencies react within the market allows you to optimize portfolios and reduce beta to Bitcoin during downturns, while maintaining upside during the bulk of a bull run.

Well established coins with higher market caps tend to keep high correlations to Bitcoin throughout the market cycle along with lower volatility (at least in terms of crazy Crypto volatility). Meanwhile, low-mid cap coins tend to be used as high risk high reward speculation tools during bull markets, but drop sharply as market sentiment shifts.

The optimal portfolio would likely re-balance periodically between a mix of mid and high cap coins, weighted by a market sentiment metric, while also hedging some exposure by shorting Bitcoin to create synthetic ALT/BTC pairs.

While it is impossible to hedge away all risk in such a new and underdeveloped market, such a portfolio may help to ease the nerves of the more risk averse investor, while maintaining exposure to Cryptocurrency as a whole.

by Matthew Tweed

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