Cryptocurrency correlation

In the past year we saw how the instability of the crypto market can cause damage to uneducated buyers. We want to give a helping hand, and provide our users with a different approach when choosing how to deal with multiple assets.

Since Coinmarketcap began listing cryptocurrencies, it’s been easy to correlate Bitcoin price swings with a large majority of the market. Debate rages as to whether the entire market is coupled with the movement of the market leader. One of the most intriguing aspects of this is the fact that the different quality of projects seems to play a very little role in the price action.  Some of the coins are moving similarly to bitcoin, while others fall almost in lock-step. In the financial world this is called correlation and it is a statistical measure of how two securities move in relation to each other. Currency correlation, tells us whether two currency pairs move in the same, opposite, or completely random direction over a designated period of time. Taking into consideration the structure of the market and the participants, this article will try to frame some possibilities for how and why this is happening.

The Pearson Correlation Coefficient

This is used by investors most of the time when analysing correlations between assets and the definition would be: The Pearson Correlation Coefficient is a measure of the linear correlation between two variables X and Y. It has a value between +1 and −1, where 1 is total positive linear correlation, 0 is no linear correlation, and −1 is total negative linear correlation.

  • A correlation coefficient of 1 means the two currency pairs are perfectly correlated and will move in the same direction 100% of the time, they have a perfectly positive correlation.
  • If the correlation coefficient is 0, it means that the currency pairs have no correlation relationship.
  • A correlation coefficient of -1 means the two currency pairs will move in the opposite direction 100% of the time, they have a perfectly negative correlation.

The correlation coefficient is a variable that changes through time, and in the past we could see different reactions from the same pairs in different time periods.

The following heatmaps are inspired by an independent study made by GeoLinkCrypto and the analysis was done for a period of three years 2016–2018. This is to observe how the relationship between coins evolved over time.

This first heat map is looking at the year 2016. What we can take from this chart here is the correlation between BTC/LTC. We also see a noticeable positive correlation between XRP/STR. This is because Bitcoin and Litecoin are part of the same family with similar functions and prospects just like Ripple and Stellar.

The visualisation of the correlation in 2017 shows something interesting.  The majority of pairs started to show dependency and increasing correlation.

In 2018 the chart looks even more curious. Like a fire spreading through the woods, Bitcoin’s magnetism seems to affect every coin if you give it time. We noticed an increase in the Pearson correlation coefficient over 0.5 for nearly all pairs studied in this report. If in the beginning we could notice correlations based on the sector of activity, in 2018 it isn’t just pairs of cryptocurrencies from the same family but all cryptos across the market tend to synchronize their movements.  We noticed how correlated a great variety of cryptocurrencies are and that this trend is more strong as the days go by. The reasons for why this happens is the subject of much speculation. We try to present some of the things we think might affect this without being biased to any of the options.

Lack of important data.

This is useful for differentiating between capabilities and future risks of various projects. Investors might consider cryptocurrencies as a group rather than individual projects with unique trajectories.

Unregulated and still young market dominated by retail investors.

Only a few investors take investment decisions based on intensive research. In general retail investors are more exposed to behavioral biases. This is often due to a lack of technical economic education. Frequent trading, buying when prices go up and selling when they go down are good examples of this behaviour.

Limited or no options for trading or investing other currencies than BTC/fiat, BTC/ETH.

Investors must first buy BTC or ETH before they can exchange one of these for the desired cryptocurrency. This pushes the dominance of BTC over the market, resulting in a “follow the leader” behaviour.

We are not wizards, so we can only guess and inform ourselves as much as possible about the real reasons of this linked movements. At Pool of Stake we think that any investor should take notice of the correlation between cryptocurrencies. This can be used as an useful tool to determine macro trends inside this crazy and volatile market. Some of the advantages of studying the correlations between pairs are:

Avoiding investing in two coins that cancel each other out.

You invest in two different cryptos but the correlation coefficient tends to -1. This means that if the price of one is going up, the other will go down, therefore cancelling out the potential profit of your acquisition.  

Diversify your portfolio.

Instead of investing 100% of your portfolio in only one coin, you should find another closely correlated coin and split some of the investment to diversify the portfolio but still take advantage of the pair’s inertia. If one asset is in danger of losing its value, you still have 50% of your account allocated to safer position.  

Trading any asset should be done carefully and we believe in times like this holding your investment is a good idea. By doing this you reduce your exposure to choppy volatile markets which can liquidate even a professional trader’s position. By staking your coins in our pool you can safely store your investment and generate a passive income based on rewards from the Proof of Stake protocols. There’s no such thing as too much information and the Pool of Stake team is focusing on empowering our users with the best analytical tools before making decisions. Our platform, through a user friendly interface, will allow everybody to track, analyze and manage their PoS portfolio and make better overall economic decisions.