Bitcoin traders can benefit greatly from knowing what correlation the digital currency has to other assets, such as stocks or Gold. By learning more about this subject, they can create stronger portfolios and manage risk more effectively.
While Bitcoin has generated significant visibility and experienced robust price gains since the first units were mined in 2009, prudent traders should keep in mind that digital currencies are very new relative to other assets.
In other words, interested investors don't have significant market history for digital currencies, and they may benefit greatly from incorporating them into a well-diversified portfolio. Doing so can help them manage their downside risk and reduce the chances of significant losses.
The basic idea behind diversification is that investors shouldn't put all their eggs into one basket. Instead, they should incorporate several different kinds of assets into their portfolio.
By combining the right assets, investors can improve their risk-adjusted returns.
Price Correlation: Key Role
This is where price correlations come in handy. To achieve effective portfolio diversification, traders should aim to combine assets whose prices have not moved in tandem historically. Ideally, if one component of a portfolio falls in value, another component will experience an equal rise.
In other words, if an investor had a simple portfolio consisting of five different assets that each made up 20% of the whole portfolio, a 10% loss in the value of one asset would result in a gain in another asset that would bring the total portfolio to the same original value.
While this may sound simple enough, it doesn't always work that easily in practice. In certain situations, correlations can surge. During the Financial Crisis, for example, many different asset classes fell in value, resulting in some experts stating that "all correlations have gone to 1."
As the global financial system provoked concerns that it may not survive, many investors engaged in panic selling. When stocks went up, investors wanted to offload them. This is what Dave Rovelli, who worked in equity trading for Canaccord Adams, told Bloomberg Businessweek.
"There are tons of sellers everywhere," Rovelli said. "People just want out."
While the Financial Crisis may seem like a particularly dramatic case of panic selling, it is not the only time that the correlation between different asset groups has been high.
During the 12-month period between January and December 1998, the correlation that large-cap U.S. stocks had with mid-cap and small-cap stocks was 0.96 and 0.97, respectively. However, when measured against 11 other asset classes, including commodities and real estate, large-cap U.S. stocks had a correlation of 0.39 over the same period.
To diversify effectively, traders can benefit from not only having this basic knowledge, but also a sense of the correlation that Bitcoin has had with other asset classes. Fortunately, some market analysts have looked into the relationship that Bitcoin prices have with the price of other assets, such as gold and U.S. large-cap stocks.
Bitcoin vs Gold
The correlation between gold and Bitcoin is certainly worthy of mention, as the two have been compared at some points.
Steve Wozniak, cofounder of technology giant Apple Inc., described Bitcoin as "pure digital gold" during a 2018 interview with CNBC.
Some analysts have described Bitcoin as a safe-haven asset, a depiction frequently used for gold.
Kristoffer Inton, an analyst for Morningstar, Inc., evaluated both the digital currency and the precious metal using Morningstar's safe-haven framework. He concluded that while gold certainly fits the bill, Bitcoin's case is not as strong.
In addition to comparing the appeal these two assets have as potential safe-haven assets, some have looked at market data to get a better sense of what price correlation exists between Bitcoin and gold.
Several analyses have failed to indicate a strong price relationship between the two. Chris Louney, a commodity strategist at RBC Capital Markets, told CNBC in February that "it's very hard to really put your hands around a tangible correlation between Bitcoin prices and gold prices for most of the history."
However, Louney noted that this has not always been the case. "Towards the end of last year, we started to notice that correlation turned at least mildly negative," he said. Right around this time, Google search interest hit a zenith as the price of Bitcoin climbed toward US$20,000.
"When we saw interest in Bitcoin peak as measured by Google trends, that's really when we saw this marginal negative relationship between gold and Bitcoin develop," Louney stated.
A separate analysis conducted by blockchain analyst Chris Burniske failed to reveal a significant correlation between Bitcoin and gold. The price correlation between the two was 0.14 between the end of 2011 and 20th June 2014. Between 27th June of that year and 24th June 2016, the relationship between the two was modestly negative, averaging -0.20.
Both the positive relationship of 0.14 and the negative relationship of -0.20 are not particularly significant, as a perfect positive correlation would be 1, and a perfect negative correlation would be -1.
Bitcoin vs Stocks
At times, Bitcoin and stocks have moved in the same direction, for example 2017, when the two experienced notable gains. Early in the following year, both the digital currency and stocks started suffering declines, which provided further evidence of the aforementioned correlation.
Even during these specific periods where the two moved in the same general direction, their correlation was fairly modest, at least by portfolio management standards.
In February, analyst Nick Colas told CNBC that the correlation between the S&P 500 and Bitcoin was 0.33 over the last 90 days. This figure was the highest that Colas, co-founder of DataTrek Research, found since he started examining the relationship between the stock index and the digital currency in January 2016.
Even at a two-year high of 0.33, the figure was below what is needed for proper portfolio diversification. Investors who want to manage risk effectively should seek to include portfolio components whose correlation is between 0.5 and -0.5.
Further, the modest price relationship between stocks and Bitcoin has not always held up.
Tom Lee, managing partner for Fundstrat Global Advisors, told CNBC that the notable correlation that stocks and Bitcoin experienced in early 2018 as both declined could be interpreted as risk-off behavior, where investors got spooked and started selling these assets. However, he emphasized that "the connection between the two is really, really limited."
Bitcoin traders can benefit significantly from learning about price correlations and their potential implications. More specifically, learning more about this subject can help them practice more effective portfolio management.
The basic idea behind diversification is creating a portfolio whose components do not move in tandem. That way, if one component declines in value, the others will rise to ensure that the portfolio maintains its value.
Unfortunately, combining assets that do not correlate is not easy in practice, especially during times of distress when investors may start selling off all assets and cause their price correlations to surge.
Market analysts have at times compared Bitcoin to gold, portraying both as safe-haven assets to a certain degree. Thus far, market research has failed to find a sustained, notable price relationship between the two. Likewise, additional research has failed to illustrate any significant price correlation between stocks and gold over any extended period of time.
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…