For anyone already operating in the cryptocurrency market or just planning to embark on their journey in trading and investing, it's important to remember and be aware of one very crucial aspect. It can easily multiply investments by hundreds of percent, or conversely, render investments worthless.
In this article, we’ll tell you what volatility is and why it has such a significant impact on any financial markets.
What is volatility?
In short, volatility is a measure of how much and how quickly the price of a financial asset (in our case, cryptocurrency) changes over a specific period of time. Put even more simply: volatility indicates how unstable the price of a coin is.
Market volatility can be of two types—high or low.
- High volatility indicates that the price of the digital asset can rapidly soar or plummet.
- On the other hand, low volatility means that the asset’s price is more stable and predictable, with no significant swings expected.
However, financial volatility does not exist in a vacuum. Just like any other phenomenon in the markets, it is closely linked to numerous factors that constantly influence each other. To better understand the basic concept of this phenomenon, let's look at what causes and triggers volatility.
1. Market sentiments. This refers to the prevailing public opinion within the crypto community at any given time.
For example, after Elon Musk's cryptic tweets, the price of DOGE soared multiple times. Why? Because in such situations, traders and investors exhibit optimism towards a particular asset. The sentiment triggers a surge in volatility, which can both boost and dent the price of the coin.
2. News. This point is closely related to the previous one. People tend to react to specific events happening in the world of cryptocurrencies.
Many still remember the collapse of the Terra ecosystem. This is an excellent (albeit sad) example of how a few negative news stories can destroy a project and devalue its cryptocurrency.
3. Trading volume. Here, we delve a bit deeper into the technical side. Let's start by understanding the term.
Trading volume refers to the number of trades or the amount of assets bought/sold within a fixed period of time. The logic is: the lower the trading volume, the higher the volatility. This is quite straightforward—the fewer trades conducted at a given moment with a specific asset, the more each of them impacts the market. This, in turn, triggers volatility.
4. Speculation. This one depends on people too. Speculators are users who trade certain cryptocurrencies based not on their actual market value but on assumptions about future price movements.
Speculators build their calculations on community sentiment, recent news, as well as general market trends. Their activity often leads to sharp price fluctuations. Sometimes, speculators go against the overall market dynamics, create confusion, and consequently, provoke volatility.
Types of volatility
Earlier, we discussed that volatility can be low or high. However, these are not the only types. To better understand the phenomenon of volatility and the market dynamics in general, let’s take a look at two more important terms.
1. Historical volatility
This one reflects how much the price of a cryptocurrency has changed in the past.
Typically, historical volatility is calculated over a specific period in the past, such as the past day, month, or year. The indicator helps investors gauge how potentially risky it is to invest in a particular coin. For example, if the chosen asset has experienced sharp and significant declines or rallies in the past, it indicates that the cryptocurrency carries obvious volatility risks.
However, this tool is far from perfect. Past market movements of an asset do not always reflect its future behaviour pattern as market conditions and community sentiments are constantly changing. Therefore, historical volatility cannot guarantee anything with 100% certainty.
2. Implied volatility
This indicator reflects the market's or experts' opinion on how the price or yield of a particular financial asset will change in the future.
Implied volatility is typically calculated based on options contracts for the specific cryptocurrency. It's an excellent gauge of market sentiment regarding future price movements. The indicator helps understand what the community expects from a particular asset. And as we discussed earlier, crypto enthusiasts' sentiments are one of the most crucial aspects influencing market fluctuations.
However, even implied volatility cannot provide an absolutely accurate forecast of future volatility. It primarily shows current market sentiments and expectations, which can quickly change depending on the situation.
To sum up, historical volatility looks back into the past to measure the actual price swings of the chosen asset. At the same time, implied volatility attempts to peek into the future to measure the market's expectations regarding potential market fluctuations.
These two indicators work quite differently, but it's somewhere between the approaches that the truth emerges. By comparing historical and implied volatility, one can understand whether the current market price of an asset is undervalued, adequately valued, or overvalued.
Measuring market volatility
The next question is how we measure the current volatility in the market and assess the situation correctly. Investors have a whole range of special economic indicators at their disposal, and we'll now see each one of them.
Common indicators and models
Here are the indicators and models that market players use to assess the level of volatility:
1. Historical Volatility (HV) Calculation
This is the most common method of assessing volatility. It's calculated as the standard deviation of percentage price changes of a cryptocurrency over a certain period (e.g., day, week, month). The higher the HV indicator for a chosen cryptocurrency, the more volatile the investment it is.
2. Use of indicators
Volatility Index (VIX): Tracks volatility changes based on option contracts. An increase in VIX usually indicates rising fear and uncertainty in the market, leading to sharper price fluctuations.
Average True Range (ATR): Measures the average price volatility over a specified period. It helps determine potential support and resistance levels, as well as trend breakout points.
3. Use of models
Generalised Autoregressive Conditional Heteroskedasticity (GARCH) Model: A statistical model used to model time series volatility. It takes into account the dependence of volatility on past errors.
Stochastic Volatility (SV) Model: Assumes that volatility itself is a stochastic process. This allows for modelling more complex volatility models than the GARCH model.
It's important to note that none of these methods allow for a 100% confident assessment of how volatile stocks or digital assets are. However, the comprehensive use of these models and indicators helps provide the most complete picture of volatility levels.
Nevertheless, when using them, it's still necessary to consider many other factors we’ve already discussed, including current news, events, and overall market sentiments.
Impact of volatility on investments
We've clarified that volatility is not a direct synonym for risk; rather, it's a financial term for “uncertainty”.
So, volatility cannot be labelled as inherently good or bad. Because of it, investments can skyrocket by hundreds of percent or be completely devalued within hours. Let's delve deeper into this topic.
Effects on stocks and crypto
A volatile market isn't exclusive to the cryptocurrency market. Fluctuations can occur in any financial market, such as the stock market. Here's how volatility affects investments:
1. Uncertainty. Volatility creates uncertainty across any market, making investment planning much more challenging. Constant price swings often hinder investors from deciding on investment assets and determining budgets for such investments.
2. Risks. Cryptocurrency prices can unexpectedly and significantly plummet due to volatility. This can lead to a decrease in the value of investments or even complete devaluation.
3. Opportunities. Volatility can also suddenly propel the price of any cryptocurrency or stock upwards. In such cases, the value of investments significantly increases, bringing good returns to the investor.
Volatility and investment strategies
It's interesting how different investors deal with the factor of economic uncertainty. Here, an investor's risk tolerance plays a pivotal role. Those willing to take risks utilise volatility spikes to their advantage, profiting from short-term price fluctuations. Conversely, more conservative investors seek to avoid volatility and invest only in the most “stable” asset classes.
Considering these differing market perspectives, there is a plethora of investment strategies. Let's now look at some of them:
1. Long-term investing. This strategy involves buying and holding cryptocurrency for an extended period of time. Regardless of short-term price fluctuations, the investor holds onto the assets steadfastly.
This strategy suits those who are confident in the long-term potential of the chosen asset and willing to risk their investments.
2. Dollar-Cost Averaging (DCA). Within this strategy, investors adhere to one main principle—consistency. This means that, regardless of market conditions, investors regularly purchase a small amount of cryptocurrency and allocate a fixed sum of money to it. Ultimately, DCA helps to buy more coins when prices are low and fewer when prices are high.
This approach works well in the long run, averaging the purchase price and mitigating the impact of volatility on investments over time.
3. Short-term investing. Here, the investor aims to quickly profit from short-term price fluctuations. Knowing they won't hold the cryptocurrency for an extended period, the asset's potential is of no interest to them.
For such speculative purposes, investors often use meme coins since they are among the most volatile cryptocurrencies.
All these strategies are fundamentally different, and it's not accurate to label one of them as the most profitable and another as inferior. Ultimately, all of them depend on three main factors:
- The investor's risk tolerance.
- Specific investment goals.
- Time horizon.
Therefore, it's crucial for anyone engaging in cryptocurrency investments to clearly define their goals and budget, and only then choose a strategy tailored to their individual needs.
Managing volatility risk
Volatility can be seen as a threat or an opportunity for profit. Anyway, it’s always essential to employ risk management rules.
Techniques and tools for investors
The most significant subtlety of volatility lies in its manipulation of human nature and weaknesses. Very sharp price swings strongly impact the emotions of traders and investors. They can evoke intense feelings, both pleasant (euphoria) and negative (fear).
Fun fact! The influence of emotions on trading and the market as a whole is so significant that in the crypto space, there's already a special tool called the Fear & Greed Index. It's used to measure and track the current crypto market sentiment.
Binance website
Here are a few useful tools that can help investors control the situation:
1. Risk management. This category includes:
Limit orders. They allow buying and selling cryptocurrency at a pre-set price, which significantly helps smooth out the impact of volatility on currency rates. The tool is also executed only at the specified price or better, thus allowing control over the entry/exit price.
Stop orders. This order is activated only when a specified price (stop price) is reached. It's mainly used for loss protection or profit-taking. Stop orders come in several types:
- Stop-loss. This order executes a sale when the price falls below the specified level.
- Take-profit. This order starts selling when a specified profit level is reached.
All these tools are available on popular trading platforms, such as Binance, Coinbase, Bitget, and many other cryptocurrency exchanges.
2. Diversification. Here, traders spread their funds across various assets, such as Bitcoin (BTC), Ethereum (ETH), Toncoin (TON), etc.
If one digital asset experiences a decline, the overall impact on the investment portfolio is lessened due to the presence of other cryptocurrencies. This helps to reduce the overall risk for the investment portfolio and protect investments from volatility.
3. Different trading strategies. Employing various trading approaches also helps to mitigate the impact of volatility. Some popular strategies include:
- Algo trading, when traders utilise specialised trading bots to profit from changing market conditions.
- Margin trading, when potential profits can be amplified through the use of leverage.
4. Technical analysis. Technical analysis involves charts and indicators used for forecasting future price movements. Many popular analytical platforms offer such functionality, for example, TradingView.
TradingView website
Technical analysis helps traders and investors to timely identify and capitalise on profitable opportunities in volatile markets.
5. News and educational resources. Knowledge is one of the most reliable ways to avoid unnecessary risks and capitalise on market fluctuations.
You can learn more about cryptocurrencies, blockchain, and all the essential market technologies in our dedicated “Learn” section.
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This article is not investment advice or a recommendation to purchase any specific product or service. The financial transactions mentioned in the article are not a guide to action. It’s not intended to constitute a comprehensive statement of all possible risks. You should independently conduct an analysis on the basis of which it will be possible to draw conclusions and make decisions about making any operations with cryptocurrency.
