Understanding Crypto · Lesson 7 · Advanced
Correlation and Fake Diversification
You recognize that several correlated crypto longs are in truth one leveraged single bet.
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Fake Diversification
Correlation runs from plus 1 (no risk reduction) to minus 1 (risk can be offset). Within crypto coins correlate strongly, many follow BTC. Long BTC plus ETH plus alts is effectively one leveraged single bet.
The general correlation principle (Kovner, Taleb: in a crash correlations go to 1) is the home topic of the risk management lesson on correlation (r-korrelation). What matters here is the crypto point: nearly all your alt longs follow BTC, and your supposed spread falls together under stress.
Your portfolio under stress.
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The key points at a glance
- Within the asset class coins correlate strongly, many follow BTC.
- In a crash correlations go to 1, alt diversification becomes an illusion.
- Kovner: eight highly correlated positions are one position eight times as large.
Deep dive
How many bets do I really have open?
The honest question is not how many coins you hold, but how many independent bets. Four longs on BTC, ETH, SOL and one alt feel like diversification, but on the chart they behave like a single position.
- Most alts follow BTC, often as leveraged beta.
- Kovner: 8 correlated positions are one position, 8 times as large.
- 1 percent risk times 4 correlated longs is really 4 percent in one go.
- This is exactly how beginners blow up their account despite small individual positions.
Why correlation jumps to 1 in a crash
Correlation is dynamic and highest exactly when you need it least. In a calm market coins rotate and feed the illusion of diversification. In a risk-off crash all correlations move toward plus 1, everything falls in sync.
- Same leverage, same liquidation cascades, often the same whales.
- Alts do not cushion the BTC loss, they amplify it.
- Historical BTC drawdowns: minus 77 to minus 93 percent.
- In those phases alts were almost always down even more.
Measure concentration risk instead of feeling it
Count correlated longs as one position. Cap your total risk in one direction instead of limiting each position on its own. Three coins that follow BTC share a common long budget below your pain threshold.
Supposed hedges flip under stress: litecoin ran temporarily inverse to bitcoin ahead of the Winklevoss ETF decision in March 2017, but relationships like that do not hold in a panic. On the demo exchange you can watch the synchronized drawdown without risk.
Sources: Burniske/Tatar, Schwager, Taleb, Goodman
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