Cryptocurrency market sentiment is often influenced by various factors, such as expert forecasts or political events. however, if you look at it in a longer time frame, it turns out that the prices of most cryptocurrencies, especially ether (eth), could mostly depend on the valuation of bitcoin (btc).
The results of research conducted by skew analysts in November 2019 showed that eth had been the most highly correlated cryptocurrency with btc for two years in a row, with an average correlation coefficient of 0.9. Meanwhile, eth was the highest correlated asset in 2019, as reported by the binance research team on Jan 1. 22, 2020.
Reading: Why does ethereum follow bitcoin
If this is the case, is it worth relying on correlation when buying crypto? could eth be less correlated to btc than commonly believed? To find the answer, Cointelegraph analyzed cryptocurrency charts from the last three years and spoke with experts with opposing views on the subject.
what is the correlation?
The concept of correlation in the stock market refers to the phenomenon when the values of two assets move in a similar direction. however, when it comes to the cryptocurrency market, the correlation can apply to all assets at once. this is what happened as a result of a massive drop in the price of bitcoin in early 2018, followed by a simultaneous drop in the capitalization of all other cryptocurrencies.
opinion #1: bitcoin is king
do the above observations mean that bitcoin is the favorite and the key influencer of the cryptocurrency market and therefore the main trendsetter? Cryptocurrency exchange charts show that a decline in the price of BTC inevitably affects the exchange rate of Eth, XRP, Litecoin (LTC), and other assets.
As such, the price influence of btc on other cryptocurrencies, and particularly eth, is a natural event in the digital asset market, according to traders and market analysts. Pierce Crosby, General Manager of financial trading charting platform TradingView, spoke to Cointelegraph about the matter:
“everything correlates to bitcoin, just like in the us. uu. stock market, everything correlates with the us uu. dollar. bitcoin is the largest store of wealth for the asset class, so everything is basically “tied” to its overall performance. it’s an important distinction to make, and one that people don’t really understand or take the time to consider. when we see asset prices going up i.e. eth or ltc we have to compare it to the broader movement of the index.”
according to the latest report on cryptocurrency volatility, published by the san francisco open exchange, the current correlation between the performance of btc and eth is significantly higher than the correlation between the values of btc and other altcoins. Analysts pointed to the actively discussed and often controversial news about the Facebook Pound as the main reason for the similar behavior of the two major cryptocurrencies.
michaël van de poppe, a cryptocurrency market analyst and amsterdam stock exchange trader, told cointelegraph that ether will always have some correlation with bitcoin as “bitcoin is king and usually the rest will remain on the market”. he compared this correlation with commodity markets, where gold is the main asset, its price changes followed by other metals.
So it seems that when it comes to the cryptocurrency market, the price of bitcoin is in fact a barometer of investor sentiment regarding digital currencies in general. therefore, if it changes due to systemic factors affecting the market, for example increased volatility in traditional markets or a change in cryptocurrency regulation, the eth rate may change in the same direction as btc.
opinion #2: eth doesn’t follow btc
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On the other hand, if there is an event that turns out to be a specific influencing factor for the price of btc, for example, the us securities and exchange commission refuses to credit an application for exchange traded funds, the correlation may turn negative, and eth may rise in price amid btc rate drop. according to van de poppe, the correlation between the two major cryptocurrencies is different at various parts of the cycle:
“in some parts the correlation is high as ethereum outperforms bitcoin, in some parts it is low as ethereum falls sharply against bitcoin while bitcoin tends to rise against usd. it’s different in different parts.”
comparison of btc and eth charts shows that some patterns of their price movements coincide over a long period of time. this correlation can be positive (from 0 to 1) or negative (from 0 to -1). a positive correlation, like the current correlation between btc and eth, suggests that if bitcoin’s price grows significantly, eth may also increase in value over the same time period. this phenomenon is especially noticeable with large price fluctuations. in particular, the btc-eth correlation is instantaneous in most cases, when coin prices change with a difference of several minutes or hours.
The question is, however, whether ether is as dependent on bitcoin as is commonly believed. It turns out that eth doesn’t always accurately repeat btc’s price movements and tends to show independence quite often.
These results were tested by the analysis of 14 significant changes in the price of btc and eth that occurred in the period from June 2017 to December 2019, when their correlation coefficient ranged from 0.26 to 0.89. observation showed that in five out of 14 cases, the eth price repeated the behavior of btc, while in four cases, the correlation was negative.
The results presented above are also supported by research conducted by Three Arrows Equity Hedge Fund CEO Su Zhu. according to his data, btc and eth have shown multidirectional dynamics nine times in the last three years.
zhu also pointed to the fact that throughout the history of the cryptocurrency market, the first quarter of the year has always shown an interesting correlation between eth and btc. every year eth demonstrated a 30% increase in price within a month, while btc always declined over the same period of time. Furthermore, ethereum price growth almost always occurred from January to June. However, from October to December 2017, BTC showed its 538% growth followed by an increase in the prices of other cryptocurrencies. van de poppe told cointelegraph on the matter:
“the reason is quite simple; the king of engines are ethereum and bitcoin and still most icos are based on ethereum. so when ethereum moves they usually follow it. the same goes for the ieos. if the binance coin is trending up, they usually follow it.”
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At the same time, according to zhu, the correlation between the two cryptocurrencies has intensified over the past year. The possible reason for that change could be that it hasn’t been a very successful year for the ethereum network, in particular, the fact that the team hasn’t released the full version of ethereum 2.0.
However, researchers at the san francisco open exchange suggest that, overall, eth’s high correlation may not suggest its reliance on btc, but rather the fact that the ethereum blockchain has received more recognition and the price of eth as a standalone asset was significant compared to other altcoins.
what’s wrong with a high correlation?
the golden rule of any investor is the diversification of the investment portfolio, which is normally achieved by acquiring assets with low correlation. therefore, if one of the assets rises in price, the other is likely to fall. the investor makes a profit in the first case and expects growth in the value of the asset in the second.
However, in the cryptocurrency market, the change in the prices of most coins usually happens simultaneously. this observation is confirmed by the binance research study published on January 1. 22. According to their results, the average correlation between the main altcoins by capitalization in 2019 was 0.7.
This means that in 70% of cases, cryptocurrencies such as ether, litecoin, eos, xrp, bitcoin cash (bch), binance coin (bnb) and others rose and fell simultaneously. therefore, using them to diversify the investment portfolio might not make sense. analyst larry chermak believes that excessive interdependence between assets creates obstacles to effective portfolio diversification.
The introduction of tokenized securities can mitigate the problem somewhat because such financial instruments are not correlated with the market in general. however, this is a separate class of digital assets that, unlike permissionless assets, requires strict kyc/aml compliance.
testing correlations is possible but difficult
In this unstable market, no one can know what the correlation of cryptocurrencies will be in a year, a month or even a week. Likewise, it cannot be argued that there is a complete and direct correlation between eth and btc prices. most of the time eth really follows btc but occasionally there are times when it shows independence and shows good results.
furthermore, according to salah-eddine bouhmidi, financial markets analyst at dailyfx & ig, there is not yet enough data to prove whether the correlation is positive or negative: “the possible positive correlation may only be becoming visible because bitcoin is still the main driver of the market. if bitcoin gains momentum, others also start to recover.” van de poppe shared the same point of view:
“Correlation is important in this market, however, the importance of correlation is difficult to prove such that proving correlations is almost impossible. There have been tests looking for correlations between stock markets and crypto markets, but no correlation was found for various reasons, while the charts imply something else. the same goes for the altcoin/bitcoin cycles.”
bouhmidi also pointed out that correlation is an important tool in the crypto market, but one should not rely on it completely, because when it comes to crypto, people have to be careful:
“A correlation can only be statistically significant if you have a huge database or sample size. cryptocurrencies are still young and do not have a lot of historical data. I would say that we can see correlations in the crypto markets, but we don’t know if they are strong yet.”
