Correlation is the relationship between two or more instruments. We can examine the correlation between certain tokens to create a yield farming strategy that remains profitable even through token retracements and market dips.
There are different reasons why one token may follow and/or affect the price of another, but we can group the correlation of assets within two distinct categories; those that are correlated due to an underlying fundamental, and those that are linked purely statistically.
An example of a statistical relationship can be shown with ETH & BTC. The correlation of this pair is extremely strong over the long run; meaning that as BTC has risen, so has ETH, and when BTC goes down, this negatively affects the price of ETH. There is no real reason why this should occur; after all, they aren’t serving the same purposes and are reaching into different sectors. ETH is a blockchain solution that involves smart contracts. BTC is a completely different platform that doesn’t support Dapps. Regardless of what the tokens’ functions are, there is a statistical correlation.
A fundamental correlation can be found in projects that are linked such as NEAR and stNEAR. Their movements are closely linked as the staked value of NEAR is derived from the token’s original price.
Understanding the correlation between tokens means we can formulate different strategies with a high degree of probability about what the outcome will be.
When investing in a liquidity pool, it is best practice to put money into assets that move independently of each other; that is, they do not correlate. In holding a portfolio with coins that are not correlated, a market dip won’t affect your balance sheet very much.
It is shown time and again that with any fall or correction, assets exhibit multidirectional dynamics. While most things will fall, there will always one or more sectors that grow. This often happens because investors want to shift their investments for more profit, hedge their bets, buy what they believe to be an undervalued token, and a whole bunch of other reasons.
Portfolio with a clear correlation
In this image we see a portfolio without a clear correlation. Even when there are falls in one coin, others grow or stay consistent.
Portfolio without a clear correlation
If a portfolio looks like this, the coins are correlated and everything moves in the same direction. This is not a good portfolio to have as market downturns can have severe consequences as you experience losses across the board.
Farming in liquidity pools is a long-term game, so each asset should have its own dynamics, meaning you can bring in more consistent returns without experiencing periods of huge losses, which can lead to liquidations and the closing of positions when leveraging cryptocurrencies.