What is Volatility in Crypto?
Volatility in the financial markets refers to the change in the price of an asset over time. Volatility is a way to measure the risk and uncertainty associated with trading an asset. Usually, the more volatile an asset is - the risker the asset is considered to be as an investment. At the same time, a volatile asset has more potential to offer either greater returns or higher losses over shorter periods than comparatively less volatile assets.
The crypto industry is known for its volatility compared to the traditional stock market, which is a huge reason why traders love to trade crypto. The lack of regulation, low entry barriers, and speculation attract traders. We can look at the historical charts of Bitcoin's price to see how volatile the asset has been since 2017.
Crypto volatility can scare many new traders due to extreme price fluctuations. At the same time, if understood correctly, volatility can create great opportunities for traders to enter and exit positions. In this article, we will delve into the reasons behind cryptocurrency's volatility and its impact on the market, as well as how traders and investors can use it to their advantage.
Why is Volatility Important For Traders in Crypto?
In Crypto, volatility enables traders to measure the risk of buying cryptocurrencies. Without volatility, traders would not have opportunities to make money in the market. For veteran traders, high volatility plays a vital role in their trading strategy because it allows for the potential for significant profits and losses depending on one’s timing of market movements.
At the same time, declining volatility makes it difficult for traders to earn significant profits due to a lack of price movement. There is a reason why volatility is known as a double-edged sword, and that is why understanding volatility can help traders understand when to be conservative and aggressive in their trading strategies.
In Crypto, there are a couple of ways to calculate the volatility of a cryptocurrency. One method is to calculate the standard deviation of the annualized returns of a cryptocurrency over a given period. It shows the range in which a security's price may increase or decrease.
Beta is another method that enables traders to compare their asset’s volatility against the entire market or another benchmark. For example, you could measure the volatility of a cryptocurrency against the stock market (the typical benchmark is the S&P 500), Bitcoin, and even Ethereum.
The beta coefficient can be interpreted as follows:
- β =1 exactly as volatile as the market
- β >1 more volatile than the market
- β <1>0 less volatile than the market
- β =0 uncorrelated to the market
- β <0 negatively correlated to the market
A high beta over 1 indicates that the cryptocurrency is volatile and has a high benchmark correlation. However, if the value is lower than 1, this could signal the volatility of the cryptocurrency is lower than the relevant benchmark.
What Triggers Cryptocurrency Volatility?
The crypto industry is still in its infant phase and early development. Bitcoin first came out in 2009. Since then, the industry has undergone significant technological advancements. Today the global market cap of the crypto industry is $9.26 Billion, compared to the US stock market value of 46,460,463.2 million (As of September 30, 2022).
Due to the smaller market size, crypto has more potential for greater price changes, which is why it has attracted influential investors - also known as “Whales.” Many of these whales are considered early adopters of crypto and control a lot of cryptocurrencies. Whether these whales buy or sell can signal confidence or lack of confidence in the market, resulting in significant volatility in the market.
Supply and Demand
From a simple economic perspective, supply and demand play a huge role in moving the crypto market. From a supply standpoint, many cryptocurrencies have a finite supply, meaning there is no ability to mint or “create” more coins into circulation. In other words, there is no central bank in crypto that can print money into existence or influence price action.
Considering that many cryptocurrencies have a fixed supply of coins, the cryptocurrency's scarcity can drive the demand for crypto. For example, Bitcoin has a limited supply of 21 Million coins. The scarcity behind a cryptocurrency such as Bitcoin can fuel FOMO (fear of missing out) since no more supply is coming into the market, attracting more buyers.
Lack of Regulation
The crypto market can be described as the “wild west,” given the unregulated aspect of the industry in many countries. For this reason, it has attracted many traders and investors who look at decentralized digital currencies such as Bitcoin as the perfect alternative to fiat money. Historically, rumors of regulation developing in the industry tend to spook traders and investors, resulting in extreme price movements.
At the same time, the lack of regulation has enabled bad actors to participate in market manipulation, resulting in market uncertainty.
Blockchain technology - the technology behind crypto is still relatively new and being developed. Since its development, crypto exchanges have experienced many security breaches resulting in the theft of coins and tokens. This type of negative news tends to scare and create fear among investors and traders, influencing the market's volatility.
Considering everything mentioned above, the crypto market is very sentimental and vulnerable to any market news. The crypto market tends to rally behind any good news, no matter how small. When Elon Musk announced he was accepting Bitcoin as a form of payment for Tesla, the market responded favorably. However, the same can be said for any negative sentiment. When China announced it was banning Bitcoin (for the third time), the market experienced a huge sell-off. Recently, we witnessed how the overall crypto market responded when LUNA and $FTT crashed.
Volatility is a great method to measure the risk and uncertainty associated with trading a cryptocurrency and can be a useful additional tool for traders in their trading strategies. To recap, the more volatile a cryptocurrency is - the risker the cryptocurrency is considered to be as an investment. At the same time, a volatile coin has more potential to offer either greater returns or higher losses over shorter periods than comparatively less volatile coins.
However, we emphasize that volatility is just one tool of many, and we urge all traders to do their own research and weigh other metrics before buying and trading.
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