Cross-Asset Correlation Analysis

_{Edited by Canva}

As this is my first time participating in the Steemit Crypto Academy Contest, it needs to be understood that I am not an expert in the cryptocurrency field. But from my humble heart, I would like to present this post to you. It comes from a significant learning process, considering that I am just an ordinary daily worker from a regular background, as mentioned in my bio.

So without further ado, let's dive in! But before that, I want to invite three of my friends to join this challenge, so we can learn new things together and revisit what we have already known. To @irawandedy, @heriadi, @afrizalbinalka, I'm looking forward to your participation.

What Is Cross-Asset Correlation?

In simple terms, Cross-Asset Correlation can be understood as the relationship between two or more types of assets invested in a cross-sectional manner. Cross-asset itself involves the trading process of two or more assets simultaneously within a single platform. According to a publication in the Financial Stability Review, it is stated that investors have the potential to decrease portfolio risk by combining assets that do not exhibit perfect correlation.

Specifically, if cross-asset correlations rise, the overall portfolio risk and resultant losses could exceed expected levels (Mosk, et.al).

Unfortunately, many people still find it challenging to differentiate between cross-asset and multi-asset when investing. There isn't a clear line between multi-asset and cross-asset. Multi-asset means trading different types of assets using the same systems, but each asset is traded separately. Cross-asset means trading various types of assets simultaneously through those systems. However, there is much connection between them.

Cross-asset usually comes from the buyer's side, where they want to mix different assets in one multi-leg trade. On the flip side, multi-asset is more about sellers. They aim to offer various assets within the same framework or technology, enabling clients to trade multiple assets without changing too many systems all at once.

What Is the Significance of Cross-Asset Strategy in Portfolio Management and Diversification Strategies?

In general, Cross-Asset plays a significant position in portfolio management and asset diversification strategies, especially in the following two aspects:

First, Risk Mitigation

Cryptocurrency markets are known for their volatility. Risk mitigation, much like dealing with natural disasters, also applies in asset management. The primary goal is clear: reduce the risk of losses and increase profit margins.

We often hear the term "high risk high return," especially in trading. I disagree with this notion. In my opinion, risk is directly proportional to pre-action calculation and mitigation efforts. The greater the mitigation efforts, the higher the level of resilience. This principle also works conversely, where smaller mitigation efforts result in increased risk and vulnerability.

Cross-asset is one of the most strategic ways to maximize profit levels and minimize losses. Why? Because by implementing cross-asset, we can clearly create and add various other possibilities when trading, so that when there is a loss, it is not a complete 100% loss.

_{Just like disasters, losses can also be minimized through mitigation efforts. Source: Pixabay}

Second, Optimizing Asset Allocation

Asset allocation is a crucial aspect to consider in cryptocurrency trading. To determine the chosen assets, a thorough research and analysis process is required beforehand. We can't just randomly choose assets for cross-trading, as it might result in more significant losses later on.

A research conducted by Robert Garrison and his colleagues titled "Cross-Asset Market Order Flow, Liquidity, and Price Discovery" discovered that cross-asset market order flow is a key component of liquidity and determining prices, especially when the market is experiencing volatility. It means optimizing asset allocation can be effectively done through cross-trading strategies, as suggested by the research findings that identify cross-asset as a 'key'.

Example: STEEM Versus BTC

In this part, I'll give an example of how assets are related using the Pearson correlation coefficient formula. This formula is often used to figure out how strong the connection is between variables, ranging from -1 to 1. The closer it is to 1, the stronger the connection, and the closer to -1, the weaker it is. I'll also share a simple analysis based on my limited understanding.

Two examples of coins that I will compare are STEEM and BTC. These two coins are believed to have similar movements. To prove this, I will compare the prices of STEEM and BTC on a daily basis for a 30 day period. Then, I will input these prices into the Pearson Correlation Coefficient Calculator on the Social Science Statistics

The price comparison:

DAY	BTC OPEN PRICE (IN USD)	STEEM OPEN PRICE (IN USD)
JAN 31	0.2170	42941
FEB 01	0.2114	42580
FEB 02	0.2131	43082
FEB 03	0.2181	43199
FEB 04	0.2168	43011
FEB 05	0.2130	42582
FEB 06	0.2119	42708
FEB 07	0.2133	43098
FEB 08	0.2165	44349
FEB 09	0.2172	45288
FEB 10	0.2234	47132
FEB 11	0.2241	47751
FEB 12	0.2250	48300
FEB 13	0.2280	49917
FEB 14	0.2253	49699
FEB 15	0.2299	51795
FEB 16	0.2362	51880
FEB 17	0.2372	52124
FEB 18	0.2349	51642
FEB 19	0.2397	52137
FEB 20	0.2429	51774
FEB 21	0.2483	52258
FEB 22	0.2463	51849
FEB 23	0.2452	51288
FEB 24	0.2451	50744
FEB 25	0.2501	51568
FEB 26	0.2551	51728
FEB 27	0.2551	54476
FEB 28	0.2541	57037
FEB 29	0.2581	62432

_{Source: Coinmarketcap}

BTC CHART	STEEM CHART

_{Source: TradingView}

Based on the above data, I want to find the correlation coefficient using the Pearson formula. After accessing the Social Science Statistics website, I inputted data for BTC and STEEM in separate columns. For STEEM prices, I entered them into the variable x, while BTC prices into the variable Y.

After pressing the "calculate" button, the correlation coefficient result is 0.9128. This is almost close to 1, indicating a strong positive correlation between these two assets (STEEM and BTC). Check out the pic below:

_{Source: Social Science Statistics}

The discovery shows that STEEM and BTC are closely connected, making them not ideal for trading together. This is due to the strong possibility that STEEM prices will rise when the BTC market is bullish, on the other hand, STEEM prices will fall in bearish BTC market conditions.

There are thousands of coins out there that move in the opposite direction of STEEM and BTC. This can be an alternative to diversify your assets and reduce the risk of losses. Personally, I trade several assets, including STEEM. I also hold some assets that move similarly to STEEM, of course i have gone through my own research before holding them. To optimize asset diversification, I make sure to also hold and trade coins that don't move in a linear line with STEEM and BTC.

For example, let's say I have $1000 to invest. I buy coin A and coin B, each worth $500, without conducting research beforehand. Turns out both coins have a correlation close to 1, meaning their price movements are highly correlated. When a bearish trend arrives, I panic and do ‘cut loss’, which makes me losses for both assets.

Now, situations like this can be minimized by applying a cross-trading strategy. Based on the example above, I carefully diversify assets to reduce the loss margin to 50:50 (in the condition of the two traded coins). I advise readers to conduct research before holding or trading an asset for the sake of our asset security.

Reference:

_{Mosk, B., Pangallo, L., & Zema, S. M. (2022, November 16). Cross-asset correlations in a more inflationary environment and challenges for diversification strategies. European Central Bank. https://www.ecb.europa.eu/pub/financial-stability/fsr/focus/2022/html/ecb.fsrbox202211_02~7abb48e333.en.html}

_{Garrison, R., Jain, P. K., & Paddrik, M. E. (2019). Cross-asset market order flow, liquidity, and Price Discovery. SSRN Electronic Journal. https://doi.org/10.2139/ssrn.3474459}

Thank you for taking time reading my post

El-Nailul