Crypto Correlations

After a dramatic move down in nearly all asset classes yesterday, the US futures markets are implying a strong rebound at the open this morning, with crypto rebounding in tandem.

In fact, after a discussion on circuit breakers and trading halts yesterday, we had the exact same thing happen this morning in the opposite direction when US futures briefly hit “limit up.” It’s an important point to emphasize: exchanges can also halt trading when prices increase too much.

This is an excellent example of what Wall Street quants describe as “serial correlation” in the volatility of markets. That is, history shows that one dramatic day tends to be followed by another dramatic day (up or down). On the flip side, quiet days tends to predict the next day will be similarly quiet. Yep, that frustration Bitcoin traders express whenever it feels like prices have been stagnant over long stretches of time is a phenomenon supported by decades of research.

I’m not aware of any asset in the world where this pattern doesn’t hold (feel free to leave a comment if you can alert me to one). So it’s interesting, yet not surprising, that Bitcoin exhibits this type of price action.

But volatility correlation is something of concern primarily to options traders. For investors who have Bitcoin as part of a broader portfolio of investments (stocks, bonds, real estate, etc.) regular price correlation is of particular interest. If Bitcoin is positively correlated to the market, it will tend to go up when the market goes up and down when the market goes down.

There was an argument that Bitcoin could be anti-correlated to the market, similar to how gold tends to do well as a safe haven asset when stocks do poorly. The surprising thing is we are starting to see a strong positive correlation between Bitcoin and the broader markets during a period like this.

This can be seen as both a good and bad thing. On one hand, the idea of Bitcoin being not very correlated to the market is a selling point to professional investors. They would rather have something that acts as a counterbalance, an anti-correlated investment that would go up during periods where their other investments are going down.

On the other hand, the increasing tendency of Bitcoin to move in the same direction as other assets could indicate that the breadth of ownership of crypto has reached a healthy new level. The 2008 financial crisis (as well as the 2007 quant crisis) showed that investors will dump all assets at the same time during crisis situations to raise cash. So this might mean crypto has found a home in the portfolios of more traditional investors than say, 5 years ago.

So we can infer some broad aspects of Bitcoin’s current relationship with the broader financial system by watching these correlations carefully. Unfortunately, they tend to evolve over time, which makes things tricky for Bitcoin traders to say the least!

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Paul Chou

Paul Chou

VI & XVIII @ MIT; GS; YC; LX. Nerdy asian kid from NJ, prankster, lifelong believer in how lucky I’ve been. Proof is my wife — that’s Q.E.D. real fast.