When you attempt to diversify your portfolio, understanding how different assets move together helps you maximize returns and smooth out market fluctuations. As in all matters, balance is important.
The relationship between the way two prices move is known as price correlation. Strongly-related commodities typically gain and lose position in tight correlation to each other, while loosely-related assets typically do not. Examining bitcoin as an asset, what is its correlation to other cryptocurrencies?
Understanding Correlations
Pricing correlations are measured with correlation coefficients, which measure how well the movement in the price of one asset offsets the movement in another. A perfectly positive correlation is a +1, while a perfectly negative correlation is a -1. +1 correlations are good for growing value, while -1 is good for effective market turbulence mitigation. +1 also assumes the maximum regarding risk, while -1 reflects the potential of all risk being able to be eliminated.
For example, an asset would be thought to have a perfect negative correlation with a second asset if it dropped in price 10 percent while the second asset rose 10 percent.
Bitcoin as a Risk Modifier
Bitcoin is a highly volatile asset. As such, it is arguable that this price volatility makes it well suited as a risk modifier. This sounds counterintuitive, but bitcoin's high risk increases its Sharpe ratio, or the amount of risk premium a risky investment can be expected to draw over a stable investment. Risk tables reflect this by showing bitcoin to be a moderate to significant modifier on risk when paired with another asset.
Litecoin, which is a bitcoin clone, has a current correlation of +0.57, suggesting that the two coins regularly move together. This is to be expected, as speculation surges in bitcoin would likely show up with Litecoin as well. Ethereum, which is based on a different codebase than bitcoin, is also tightly correlated at +0.5. This is due to the fact that much of Ethereum's financial underpinning is tied to bitcoin.
This tight relationship with most of the altcoins in the market gives the appearance that the market moves with bitcoin. In a sense, it does. As the motions of a large company like Apple can make stock prices dance, bitcoin can do the same by the virtue of its market capitalization.
However, there are coins like Bitcoin Cash that are positioned to move against bitcoin. Its correlation of +0.19 is the most negatively-set of the altcoins for bitcoin. This is due to Bitcoin Cash being a rejection of bitcoin's policies and traditionalism.
Here is a look at a 365-day correlation matrix for bitcoin, popular altcoins, and other popular assets like S&P 500 stocks and gold.
Here is a graphic representation of the correlation between various altcoins over the past 365 days.
Trends and Events
It should be noted that the market tends to move in respond to the news and world events. This makes relying solely on correlations to predict the movement of an asset dangerous. For example, an announcement that the FCC is cracking down on altcoin or that a major Japanese exchange lost a minimum of $534 million in stolen NEM would make the market move in ways inconsistent with correlation.
Trends in the market also tend to have a tidal effect on altcoins. For example, the current bearish market following bitcoin's "price adjustment" has led to a deflation of speculation for the entire market and slumping prices.
Prices that rise or fall all at once should not be read as correlation. This is simply a market response, which is best dealt with by staying calm and ignoring it.
In Conclusion
Price correlations are important tools for explaining how assets respond to each other. By maximizing their potential, it is possible to reduce the risk in your portfolio, making your long-term investment that much safer and making it easier to stock a well-diversified portfolio.
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