How to use crypto correlation for better risk management

Key takeaways

• Crypto correlation measures the relationship of market price movements between cryptocurrencies and traditional finance assets. 
• A coefficient number ranging from +1.0 (positive correlation) to -1.0 (negative correlation) is used to give insight into risk management with crypto correlation. 
• Investors use crypto market correlation strategies to hedge against market volatiles, building a portfolio of assets with varying degrees of correlation to crypto price fluctuations. 
• Improving risk management with crypto correlation can be done using helpful tools and platforms such as Blockchain Center, DefiLlama and Coin Metrics.

Managing risk with cryptocurrency investments is tricky. The market is volatile, making it critical to build a balanced investment portfolio, which reduces exposure to aggressive market fluctuations. You might do this with a varied basket of digital assets alongside traditional equities, bonds and commodities. 

Using a crypto correlation enables you to gain a clear understanding of how assets in your portfolio react compared to one another. You can then use this insight to improve your risk management approach to create a balanced and robust portfolio.

What is crypto correlation?

Crypto correlation is a mathematical calculation showing the relationship in market price movements between cryptocurrency and traditional finance assets. The technical term for the measurement is called the correlation coefficient, and it can range on a scale of +1.0 to -1.0. This means the crypto correction can either be a positive correlation, a negative correlation or no correlation.  

• Positive correlation: It happens when both assets move in the same direction. It is anything with a coefficient exceeding 0, with a perfect correlation being +1.0, when the two asset types move in the exact same trajectory. 
• Negative correlation: It occurs when assets move in the opposite direction to each other. As the value of one increases, the other drops in value. The negative is a coefficient of less than 0, with -1.0 when the assets move in value the same amount but in the opposite direction.
• No correlation: It happens when the price movements of one asset are completely independent of the other. In this scenario, there is no discernible relationship between the two assets, either positively or negatively. A correlation coefficient of 0 signifies that the price changes of one asset do not influence or align with those of the other in any consistent way.

The correlation coefficient (denoted as r) is commonly calculated using the Pearson method, which measures the strength and direction of a linear relationship between two variables. Here is the formula to calculate it: 

However, other methods also exist, such as the Spearman rank correlation and Kendall’s Tau, which are used for non-parametric data and monotonic relationships. These alternative methods can provide valuable insights depending on the nature of the data being analyzed.

Understanding the evolving relationship between Bitcoin and gold

As an investor, you might want to learn the correlation between Bitcoin (BTC) and gold. Gold is often viewed as a store of value, rising in price when risky equities drop.  

The chart below illustrates the 30-day rolling correlation between BTC and gold from 2017 to late 2024, showing how their price movements have related to each other over time.

Historical trends observed

• In October 2018, the correlation reached a deep negative value (-0.58), indicating that when gold rose, Bitcoin tended to fall, and vice versa.
• The correlation fluctuated between positive and negative over the years, reflecting shifting investor sentiment and market dynamics.
• By Nov. 13, 2024, the correlation stood at -0.36, suggesting a moderate tendency for Bitcoin and gold to move in opposite directions, though not perfectly so.

How gold and Bitcoin reacted to US election results

The 2024 United States presidential election has significantly impacted asset trends, with gold prices dropping by over 4% after Donald Trump’s victory, settling at $2,618 per ounce. Market optimism drove US stock indexes higher, weakening gold’s safe-haven appeal.  

A strengthening dollar, driven by expected trade tariffs and reduced interest rate cuts, made gold pricier for foreign buyers, further pressuring prices. Meanwhile, Bitcoin’s moderate negative correlation with gold (-0.36) underscores their distinct investor dynamics, as political shifts affect inflation expectations and monetary policy. 

While gold retains its reputation as a safety net, its immediate allure has dimmed amid a volatile post-election landscape.

Why crypto correlation matters for risk management

Correlation is a key metric for an investor’s crypto portfolio risk management and helps to understand how to reduce the overall risk position. It can be used to give perspective on the nature of markets and how they react to one another when crafting your crypto portfolio diversification strategies.

Cryptocurrency is a particularly volatile market, which means traders and investors need to regularly assess their exposure. In simple terms, most cryptocurrencies are risky assets. Their price can spike and crash quickly in a matter of hours or days. When prices are strong, investors might look to cash out and take profits. This reduces their position size and exposure to future volatility. 

Traders then might look to reinvest in assets with less volatility or a negative correlation to crypto. When market prices tumble, their portfolio is protected or even benefits from this hedging strategy. 

Alternatively, some investors actively look for assets with a positive crypto correlation. This helps them understand how the market reacts to economic events. Plus, find other assets to invest in without the risk of buying and holding cryptocurrency directly. Exchange-traded funds (ETFs), particularly those related to blockchain and cryptocurrency-focused funds, provide an indirect way to gain exposure to the crypto market. 

Diversify your crypto portfolio

When it comes to managing investment risk, diversification is key. It enables you to create a portfolio that spreads out risk. This means the performance of your investments is not reliant on a single or small group of assets. That way, you can reduce losses when a particular asset class takes a downturn or even profit. 

Understanding correlation in trading allows you to build a well-balanced portfolio. Without this insight, you might accidentally end up with poorly diversified investments. 

For example, if you hold cryptocurrency but want a balanced portfolio, you’d want to adopt assets with no negative correlation. So, if the crypto market crashes, other parts of your investments will be protected.

Did you know? In recent years, the correlation between cryptocurrency and the S&P 500 has been increasing from 0.54 to 0.80, indicating that crypto is moving in tandem with equities. 

How to measure crypto correlation

Measuring crypto correlation requires complex calculations. Fortunately, there are several tools and platforms to help you with your calculations. 

Below are the steps to using correlation in crypto trading: 

1. Select your data source from trusted financial data providers, such as CoinMarketCap, CoinGecko and Bloomberg.
2. Download or record historical prices for the assets you want to analyze.
3. Choose your correlation method; the common ones are Pearson, Spearman or Kendall. 
4. Use data analysis tools like Excel, Google Sheets, Python or R to understand your correlation data and build graphs to visualize insights.

Tools for analyzing crypto correlation

Several companies have prebuilt cryptocurrency trading tips and tools based on correlation. This saves you the time and complexities of data analysis, plus gives you live trading insights.  

BlockchainCenter offers an interactive crypto correlation tool that gives you the ability to compare the top coins, plus gold, and the S&P 500 to improve diversification using crypto correlation.

DefiLlama gives you access to a Pearson coefficient for Bitcoin and altcoin correlation trends, which can also be personalized with your own data. 

Coin Metrics provides an advanced platform with multiple correlation methods, as shown in the below image.

Did you know? Sir Francis Galton invented the correlation coefficient in the 1880s when he introduced the term “co-relation” for the first time in scientific literature. He went on to describe his measure as the “index or correlation.”

Common mistakes when using correlation in risk management

Using correlation offers useful insight for risk mitigation in crypto investing. However, there are several common mistakes to avoid costly pitfalls. Adding to this, investors might also need to adapt strategies and coefficients based on new market conditions. 

Here are the mistakes to avoid in your crypto correlation risk management:

• Over-reliance on historical data: Analyzing crypto correlation for trading relies heavily on historical data. History, however, is no guarantee of the future — at best, it echoes. There are myriad factors impacting future asset economics, including regulation changes and macroeconomic trends. 
• Ignoring market conditions: Event-driven volatility can drastically alter correlations, an ignorance of which leads to unexpected portfolio performance. In addition, periods of market stress can cause correlation changes, which expose a portfolio to higher systematic risk. 
• Data misinterpretation: Inaccurate calculations or misinterpretations lead to flawed portfolio risk assessment. Making decisions based on misunderstood data creates inefficient asset allocation.

Being mindful of these risks helps investors make informed decisions and manage portfolios more effectively.

This article does not contain investment advice or recommendations. Every investment and trading move involves risk, and readers should conduct their own research when making a decision.