The world of digital currencies, which started with the introduction of Bitcoin, is now flooded with more than a thousand different cryptocurrencies. While the base of all these currencies is blockchain technology, some have been introduced to fund special projects or achieve special goals. However, one thing you will notice about the movement in the values of cryptocurrencies is that a large number of them are related to each other and move in tandem. One can also find several cryptos that share a negative relation with Bitcoin or other cryptos. This correlation between various cryptos needs to be taken note of while developing a strategy for investing in digital currencies.
An analysis of movements of various cryptocurrencies has revealed that most cryptos are dependent on each other when they perform badly, but relatively independent when they do well. So, they are likely to crash at the same time, while increasing independently. Let’s see how a correlation coefficient can be used to develop a crypto trading strategy.
The Pearson Correlation Coefficient is a very useful measure of finding out the correlation between two currencies by analyzing their price charts over a specific period of time. The value of the correlation coefficient ranges between -1 and +1. Now let’s see what the various values of this correlation coefficient mean:
So, how is this information about the relationship between two currencies useful?
Although the crypto correlation coefficient strategy can be highly useful, one needs to remember that the level of correlation between two cryptos may change over time. One factor that can erode correlation between two cryptos is when investors sell off their main holding, generally Bitcoin, to buy another smaller coin that they believe can climb faster when the overall crypto market is growing.
Investors also need to remember that it is very rare or uncommon to find a perfect correlation between two digital currencies. So, it is always a good idea to use the correlation coefficient along with other research about the crypto to formulate an investment strategy.
Another option while developing an investment strategy is to use the Spearman correlation coefficient, which does away with the weakness of the Pearson coefficient. The latter assumes that the relationships between two variables is linear. In case of nonlinear yet meaningful relationships, the Spearman correlation coefficient is more appropriate, since it takes a ranking of all the data points in the sample and runs the Pearson correlation on the new rankings data. It compares the two variables based on how their rankings move together. Now, a Spearman coefficient will find the correlation between a perfect exponential relationship as 1 while Pearson would say it is positive but not perfectly correlated.
So, while developing a correlation coefficient strategy for crypto investments, one needs to check whether the relationship is linear or non linear and choose the Pearson or Spearman coefficient accordingly.
If you liked this educational article please consult our Risk Disclosure Notice before starting to trade. Trading leveraged products involves a high level of risk. You may lose more than your invested capital.