Understanding Volatility in Crypto: A Comprehensive Guide

May 19, 2023

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Introduction

What we have been noticing

The world of cryptocurrency or crypto has seen tremendous growth in recent years, with people flocking to invest in the market in the hopes of making a fortune. However, the extreme fluctuations in crypto valuations have resulted in both gainers and losers, regardless of which crypto they invested in. It is not uncommon for two investors to invest in Bitcoin, but have vastly different outcomes due to timing. This is because crypto is often associated with high levels of volatility, prices can fluctuate wildly, with sudden gains or losses occurring within a matter of hours or even minutes. For example, Dogecoin’s value plummeted by 21% in a single day on 3 April 2023.

But why is crypto so volatile? The answer to this question lies in the fact that cryptocurrencies are not backed by any intrinsic value, unlike traditional assets such as gold or diamonds. In this article, we will delve into the concept of volatility in crypto, exploring its causes and effects on the market, as well as strategies to mitigate the risks.

Key topics this article will cover:

What is volatility in crypto and why does it matter?
Types of volatility in crypto
10 Factors contributing to volatility in crypto
Strategies to mitigate crypto volatility risks
Conclusion: Future outlook for crypto volatility

What is volatility in crypto and why does it matter?

In traditional finance, volatility refers to the measure of the dispersion of an asset’s price over a period of time. It shows how much a security's market price fluctuates around its average price. Generally, the higher the volatility, the riskier it is to invest in that asset.

Similarly, volatility in digital assets as crypto refers to the degree of fluctuation or rapid and unpredictable changes in the price of cryptocurrencies, such as Bitcoin or Ethereum, over a particular period. However, there is much higher volatility in the overall crypto market than in traditional finance. As a result, major cryptocurrencies like Bitcoin and Ethereum have their own volatility indexes. The most popular is the Bitcoin Volatility Index (BVOL) which measures Bitcoin's price fluctuation. Let’s take a look at the example below.

The graph shows the performance of two different markets over time, one with high volatility and one with low volatility. In the high volatile market, the line on the graph appears to be very jagged and unstable, with frequent ups and downs that are often quite significant. This indicates that the market is experiencing a lot of fluctuations and uncertainty, and that investors are likely to see a lot of risk and potential reward. On the other hand, the low volatile market appears much more stable and predictable, with a smoother line that shows little variation over time. This suggests that the market is relatively calm and that investors are likely to encounter less risk and more stability when investing in this market.

Volatility is an important measure of an investment’s risk. In most cases:

The higher the volatility, the riskier the investment.
The lower the volatility, the less risky the investment.

Types of volatility in crypto

There are three main types of volatility that are relevant to the crypto market: historical volatility, implied volatility, and realised volatility. Each of these types of volatility measures the degree to which the price of a crypto fluctuates over a given period of time, but they do so in different ways.

Historical Volatility:

Historical volatility looks at how much the price of a crypto has varied in the past, typically over a period of 30, 60, or 90 days, and can help predict how much it might vary in the future. It is calculated by taking the standard deviation of the logarithmic returns of a crypto over the given time period. Historical volatility is a backward-looking measure that can be used to forecast how much a crypto is likely to fluctuate in the future.

Implied Volatility:

Implied volatility is a forward-looking measure of how much the market thinks the price of a crypto will vary in the future. This is calculated based on the prices of options contracts. Options contracts are contracts that give the buyer the right (but not the obligation) to buy or sell crypto at a specified price on or before a specified date. The more expensive the options, the higher the implied volatility.

Realised Volatility:

Realised volatility is a measure of how much a cryptocurrency's price has actually fluctuated over a given period of time. It is calculated by taking the standard deviation of the logarithmic returns of a crypto over the given time period. Realised volatility is a useful measure for evaluating the accuracy of historical volatility forecasts and for assessing the performance of trading strategies that rely on volatility forecasts.

Understanding the different types of volatility in crypto is important for investors and traders who want to manage risk and make informed decisions about buying, selling, or holding cryptocurrencies. By monitoring historical, implied, and realised volatility, investors can gain a better understanding of how the crypto market is likely to behave in the future and adjust their strategies accordingly.

10 Factors contributing to volatility in crypto

There are several factors that contribute to volatility in the crypto market. These include:

Supply and demand: The demand and supply of cryptocurrencies can impact their price and lead to fluctuations. Since the crypto market operates 24/7 and is decentralised, it can be highly reactive to even small changes in supply and demand, leading to frequent and sudden price changes.
Lack of regulation: Unlike traditional financial markets, the crypto market is not regulated by any central authority. This lack of regulation can lead to market manipulation and insider trading, which can result in sudden and dramatic price swings.
Market Manipulation: Due to the lack of regulation in the crypto market, market manipulation is a significant contributor to volatility. Whale investors and traders with large amounts of capital can manipulate the market by buying or selling large amounts of a particular cryptocurrency, which can cause other investors to follow suit, resulting in significant price movements.
Speculation and hype: Many investors buy cryptocurrencies based on speculation and hype rather than underlying fundamentals. This can lead to market bubbles that eventually burst, causing significant price drops.
News events: News events can significantly impact the price of cryptocurrencies. For example, positive news about a particular crypto may lead to an increase in demand, driving up the price.
Market sentiment: The overall sentiment of the market can also impact the price of cryptocurrencies. If investors are optimistic about the future of a particular cryptocurrency, they may be willing to pay more for it.
Liquidity: The liquidity of a crypto can also impact its volatility. Cryptocurrencies with low liquidity are more prone to rapid price changes due to the low trading volume. This means that even relatively small buy or sell orders can have a significant impact on the price of a cryptocurrency.
Lack of intrinsic value: Unlike traditional assets such as stocks or commodities, cryptocurrencies do not have an intrinsic value. Their value is entirely based on supply and demand, which can lead to sudden price swings as market sentiment changes.
Technology and Innovation: The crypto market is built on a rapidly evolving technology, which can lead to changes in the value proposition of different cryptocurrencies. For example, the introduction of new blockchain protocols or the development of new use cases for cryptocurrencies can lead to significant price movements.
Security concerns: Security breaches and hacks can lead to decreased confidence in cryptocurrencies, leading to price drops and volatility. Security concerns are particularly critical for cryptocurrencies since they are not backed by any physical asset or government, making it challenging to retrieve stolen or lost funds.

Strategies to mitigate crypto volatility risks

There is no guaranteed way to eliminate volatility in the crypto market, but there are strategies that can help mitigate the risks associated with it. It's important to do your own research, understand the risks involved, and have a solid investment plan in place. Here are some strategies to mitigate crypto volatility risks.

Diversification: One way to mitigate crypto volatility is to diversify your portfolio across different cryptocurrencies. By doing this, you can reduce the risk of one particular cryptocurrency experiencing a significant drop in value.
Dollar-cost averaging: Another way to mitigate crypto volatility is to use a dollar-cost averaging strategy. This involves investing a fixed amount of money at regular intervals, regardless of the price of the cryptocurrency. This can help you avoid investing all your money at a time when the price is high.
Hedging: Hedging involves taking a position that offsets potential losses in another investment. For example, investors can use futures contracts or options to hedge their cryptocurrency positions.
Stop-loss: Setting stop-loss orders can help minimise losses in case of sudden drops in cryptocurrency prices. It's also important to have a risk management plan in place, which includes understanding the risks associated with different cryptocurrencies and having a plan to manage those risks.
Fundamental analysis: Conducting fundamental analysis can help investors identify the intrinsic value of a cryptocurrency and make more informed investment decisions. This approach involves analysing the underlying technology, adoption rates, and market demand for a particular cryptocurrency.

Conclusion: Future outlook for crypto volatility

Volatility is a common occurrence in the crypto market. It can present both opportunities and risks for investors. Understanding what volatility is and how it affects cryptocurrencies is essential for investors who want to navigate this challenging market successfully. By staying informed, diversifying their investments, and being patient, investors can potentially make a profit while managing their risk.

Watch the video below to learn more about volatility and how it affects crypto. Don’t forget to like and subscribe so you don’t miss out on important updates and our newly uploaded videos.