Bitcoin

Bitcoin and technology stocks: can we effectively trade the correlation between them?

Everyone is concerned about the correlation of BTC with the stock market. OK, maybe not everyone. But maybe they should be concerned too. Or maybe this correlation opens up additional trading opportunities? Maybe.

If you are our regular reader, you know what happened after the “Covid” crash in March 2020.

Before that, the correlation between bitcoin and the stock market was virtually non-existent. However, since March 2020, it has been positive on average.

And that’s not what you would look for when building a diversified portfolio. Ideally, you should try to select uncorrelated assets to increase risk-adjusted total returns. That was the argument I used to convince old-school investors to invest a small percentage of their capital in BTC.

In recent years, it has become much harder to sell that idea.

And the chart above shows the correlation with the S&P500. Because if you look at the correlation with the NASDAQ index, it looks even worse. The monthly correlation between BTC and NASDAQ has reached 80%. That is very, very much!

If you zoom out and look at the 6-month moving correlation, the regime change becomes even clearer. There is a clear difference between the time before and after the “pandemic” collapse.

Why is this the case? I do not know if it is possible to answer this question clearly and exhaustively.

I suspect it has to do with the unprecedented monetary and fiscal stimulus given by governments in response to the pandemic crisis. Trillions of dollars flooded into the market and flowed directly into financial assets. Suddenly, investors had to decide where to put all that money.

Naturally, they rushed into fast-growing stocks: technology stocks, Bitcoin, and the crypto market in general. As a result, many investors hold both bitcoin and tech stocks in the same portfolio. But that’s not all: they classify both as risky assets. This could explain such an increase in correlation between the two.

Based on a fairly large sample of investors, however, I can’t say for sure if this version is correct. But if I am correct, there are two ways to revert to an uncorrelated mode:

A major market crash would cause some rebalancing in most portfolios. This could result in washing the “hands” out of the market that put bitcoin and technology stocks in the same asset class.

The return of the Bitcoin narrative as a means of saving capital would naturally lead to some decoupling of the exchange rate. People do not trade the means of saving in the same way they trade risky assets.

These options are not mutually exclusive, but given the Fed’s struggle with inflation, I would say a crash and reset are more likely.

Either way, there’s not much you can do about it. Unless.

Can’t this high correlation be used for short term trades?

The correlation number assumes that Bitcoin and NASDAQ move in the same direction during the trading day. If you plot the daily return ratio of Bitcoin and NASDAQ from March 2020, it looks pretty tasty.

So you can watch the NASDAQ move and bet that bitcoin will follow it on the same day. If you are a day trader, it seems possible to look for a signal.

I personally don’t daytrade and don’t recommend it to most people. But maybe we can expand our time horizon a bit?

There is a clear correlation between the daily movements of BTC and NASDAQ. But can NASDAQ be used as a leading indicator for BTC one day ahead? And for two or three days ahead? Let’s check.

We can plot the correlation between bitcoin returns on day 0 and NASDAQ returns one day, two days and three days ahead and see if the correlation exists.

So, drum roll…

How it works?

No, that’s not how it works. At least not in such an obvious way.

As you can see, the linear regression line gets flatter and flatter as you move away from the intraday indicators. Even a one-day shift no longer results in a significant correlation.

In case anyone is wondering what happens when you remove the weekend effect from the calculation (NASDAQ doesn’t trade around the clock like Bitcoin does), the picture is the same. Nothing new.

We could do a more complicated analysis of the relationship between BTC and NASDAQ, like the one we did to analyze the relationship between BTC and ETH. But that would be too much of a departure from the big picture, in my opinion.

In my opinion, the stock market is simply huge compared to Bitcoin’s market cap: $15 trillion for the NASDAQ and $40 trillion for the S&P500 versus ~$1 trillion for Bitcoin.

So this correlation should be viewed as a gravitational field of sorts affecting the BTC price. If the Fed crashes the stock market, we should not expect bitcoin to somehow avoid a big drop.

And in this case, it is important to position yourself properly to survive this fall. And the asymmetric potential long-term returns won’t go away either.

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