Might Crypto Be A Hedge After All?

Stocks are having another rocky week, yet cryptocurrencies seem to be doing OK. Could it be that they are actually acting as a hedge against stock market risk?

In the very short term, the answer might be yes. As I write this, bitcoin is up just over 3% for the past week while the S&P 500 (SPX) is down about 0.9% over that span. Items that rise when others fall are wonderful hedges. But one week is hardly a meaningful timespan. We want hedges to display that sort of behavior over a longer time span, not just a random week. If we look at year-to-date (which admittedly is only 2 weeks at this point), we see bitcoin trading -9.6% while SPX is -3.3%. That is the worst type of hedge – something that moves in the same direction, only more. We need to step back and see if there is a rationale for considering bitcoin – and by extension other cryptos – display hedging behavior over an extended period.

First, let’s define what we consider a good hedge. For starters, we like to see a hedge that inversely correlates, or at least decorrelates, with the item being hedged. Shorting SPX futures against a stock portfolio of SPX stocks is a wonderful hedge if done properly. One would go up while the other goes down. But those hedges are from the same asset class.  Investors often desire hedges that are in another type of investment. Over the past year, bitcoin has indeed displayed a near-zero correlation with SPX even as both rose over that period. The reason for the decorrelation is a problem, however. Bitcoin had two major dips after a long period of rising prices over the past year – a very sharp drop in May and a longer one that has persisted since October. Meanwhile, SPX continued to generally rally over those periods. Those drops in bitcoin created the decorrelation, not a systematic time when one rose and the other fell. And over a 2-year period the correlation is actually quite high, with an R^2 of about 0.85 when we compare log values. Remember, both have moved sharply higher since the March 2020 covid crisis, and somewhat in lockstep prior to the incidents mentioned above. The same applies to a 5-year period as well. Things that move together are not hedges, just different choices.

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Disclosure: SECURITY FUTURES

Security futures involve a high degree of risk and are not suitable for all investors. The amount you may lose may be greater than your initial investment. ...

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