Cryptocurrency Volatility Explained

The cryptocurrency industry saw significant market activity in 2017, where it would go to levels not seen before. Bitcoin started at $1,000, and then it flew to $21,000. The leading digital asset would then take a breath, pause, and reverse course starting in early 2018. That was the year that the markets began to become more humble. People would go from talking about the moon and Lamborghinis to talking about real innovation and working hard within the cryptocurrency industry to make it more valuable.

We know that 2018 was a stark reminder of what can take place when markets become excessively irrational. Many were able to learn about playing with money in a conservative fashion instead of getting caught up in the reverie of the markets before the eventual asset depression. A great portion of traders were able to learn that they would need to be wise with their trading decisions and make the right moves.

If they didn’t they could run into significant volatility as the situation which took place in 2018. Recall that we did not have a case of mind volatility but extreme volatility in the digital asset market that made many swear off of cryptocurrencies forever.

Yet, from 2018 to 2020, we have seen cryptocurrencies come back to a more respectable level before dipping again at various times and resting back at above the double digit thousands range in the fall of 2020. In a nutshell, we see that cryptocurrencies are continuing their long trend of going up and down swiftly within a short time frame ever since their initial birth.

Some have even gone to write off the space due to its highly volatile nature, stating these assets cannot be currencies due to the wild fluctuations that regularly take place.

Further, we see that the most significant market via the market capitalization metric – the most respectable leading digital asset, bitcoin went and gained over 20,000% within one year. Returns like that are enjoyable, but the ensuing crash can be disheartening.

The high prices drew a lot of interest to the cryptocurrency market, and then low prices shook the weak hands out of the market. Yes, this was seen in 2018 when the overall value in market capitalization went from over $790 billion to less than $150 billion, where many coins would decline over 80%.

That points to a significant loss of capital for those who sold at bottom levels and purchased at higher levels.

But we want to understand what are the inputs that go into the beautiful technology that is cryptocurrency and its relation to volatility. We want to see why people are still in the cryptocurrency industry despite the chance of significant loss of capital.

Let’s take a look at volatility a bit more deeply.

The Nature of Volatility in the Cryptocurrency vs. Traditional Industries

In general finance, experts know volatility as a way to measure the diffusion of a stock’s price. Stated simply, volatility is the distance and frequency at which an asset strays from the mean given a certain timeframe. An asset is volatile when its price rapidly rises and declines within a given timeframe.

In fiat markets, many understand that there is a hierarchy when it comes to safety and minimal volatility.

First, we have government bonds such as treasuries, treasury inflation-protected securities, and other similar government bonds. Then we have gold; it is a relatively stable asset that will not see as much volatility because of the nature of the metals market.

The next level is that of private-sector bonds such as those from Apple, Amazon, and other firms. These bonds are not too volatile and are typically one rung above government bonds in terms of more volatility.

Real estate is not usually volatile and can be on the same level as bonds. That is why you see more people with the dream of owning a house and keeping it for a while as they want to have value in an asset that goes up over time.

Stocks are mid-level volatile. That means that stocks will have certain times of peace but will have more movement. The reason why stocks will have more movement is that they are tied to company, economic, political, and geo-political activity. They are higher in volatility than bonds.

Cryptocurrencies are the next asset class. They are volatile because they are a new class of assets, and people are trying to figure out how they make sense in the world and within a portfolio. We know that these are mid-level to high-level volatility because of how quickly they can move up and down in value.

The Comprehension of Risk via Volatility in Cryptocurrency

Everyone who seeks to preserve value over the long-term will seek to make investments. They will make investments by understanding the level of risk present and the rewards that will come about due to those risks. Investors will note their risk tolerance and then take investment actions accordingly within the markets.

You might be more risk-on if you are young, but if you are older, you do not have time to play games and take chances with your money, so you will be more cautious depending on your age and level of wealth. Your risk tolerance determines your appetite for volatility.

For instance, if you are 85, bitcoin going up will be great for your portfolio, but it going down to over an 80% loss within one fell swoop can obliterate your savings. As you get older, you must preserve what wealth you do possess. That is why older people have their money, usually in pensions, and more stable funds that will continue to pay out general income and appreciate slowly.

But a 28-year-old is prone to be more risk-oriented where they can buy bitcoin in abundance, if they have the cash, and want to see their portfolio value increase. That is why it is the young, which will be more interested in technology investments that range from Facebook to Bitcoin and pre-IPO startups. The more risk you take on should be correlated with the level of potential return. You don’t want to take on risk for no reason. The market should compensate you for the risk you are underwriting.

Investors understand this concept as the risk-return ratio. It is a must because they must check the volatility and risks before placing hard-earned money into an asset to preserve capital. Digital assets require a great deal of care and handling because they can make you wealthy but also tear you down in down markets.

Volatility in Cryptocurrency and Foundational Factors

The market is seeking to understand the risks present within bitcoin and if it will offer what it promises.

The two promises bitcoin provides are: peer-to-peer cash and a payment processing system. Then it offers a store of value promise where individuals can avail the value of bitcoin and use it to minimize their worries of currency devaluation and loss of purchasing power. The third component is the amount of holders who believe in the promises. These three components affect volatility in a great regard.

Let’s take a look at the first one and then the second one afterward. We have had government denominated currencies for quite some time now.

Bitcoin has significant value because it disintermediates the government from money. It is a new phenomenon because we have been in a fiat currency world for a few centuries now.

Now, here are a few properties of fiat money. They are not worth anything on their own. They are backed by governments and have power because of the existing government. Gold and silver used to be in use but were also manipulated in some form and fashion by the government. Further, fiat is all about the credit present within a system. Fiat is also supply and demand based.

The first country to utilize fiat currencies was China, around 999 AD. In fact, the first fiat currency in China came because they were running out of precious metals to service the demand for money so they quickly created paper currency that would have the backing of precious metals. Then the western world took it on.

It spread, and now the whole world has different nations with fiat currencies.

There is no intrinsic worth to cash and is only present with value if the government is willing and able to preserve its value. The government is the central power that must do what it takes to keep the currency viable throughout time by monitoring transactions and minimizing counterfeit activity.

That is why people are always worried about inflation, the rise in the prices of products and services, and loss of purchasing value with government-related debt. The more the government generates notes, the lower the value of these notes or currency in your pocket if demand declines.

But bitcoin changes things because it takes the government out of the money equation within this new system for the most part, and that is where the volatility comes from. If you followed along, bitcoin came into existence when the centralized monetary system was going through significant upheaval and a global recession. We then saw a further correlation with bitcoin spikes during situations such as the Cyprus financial crisis and other centralized governmental fears.

You could see the rise with private market activity and governmental concerns in several ways. As you can see, from Zimbabwe to Turkey and Venezuela, places that see high inflation or low value in currencies, bitcoin becomes a strong store of value asset. People appreciate that it has a sound money supply and can be reliable when the fiat currencies are falling down.

Further, we see that the ability to send money without using Paypal or centralized processors genuinely make a powerful difference for users. As more people believe in the promise of bitcoin, others follow because of the price increase.

Finally, suppose there’s government regulation or potential to minimize bitcoin’s free flow by financial authorities, cyberhackers, and other entities. In that case, you see that bitcoin may face a short-term decline. The asset class is still tiny when compared to gold, stocks, and bonds so there is much room for growth.

Now, that you understand the fundamental volatility factors influencing bitcoin, let’s take a look at more surface level factors affecting bitcoin and leading to volatility.

Surface Level Factors Affecting Bitcoin

Remember, we talked about the fact that bitcoin is still a small portion of the market? That is because it is an emerging asset class. That means that bitcoin only came about in 2009 and is one of the newest asset classes in the world. Yet, it is still alive and has stayed strong through the general market declines, indicating its staying power.

Time

Still, while stocks and bonds have been around for over 60 years, cryptocurrency is relatively young and new. The truth is that new markets will have more volatility due to lack of structure, more uncertainty, and lack of historical data.

Uncertainty

The uncertainty revolves around blockchain technology, hacks, and the general safety present within crypto markets. We see that new technologies, projects, and companies in these new domains always have hype cycles where promises are made, enthusiasm increases, and declines.

The fact is that new technologies can shift society but can take time to occur and create long-term value. Finally, new technology projects will always see substantial failure due to the fact that it is how society learns.

Next, investors don’t know what the future holds when it comes to new technology. These technologies can shift to new ones in the blink of an eye, so people try to figure out how to value these assets, and volatility occurs. 

Use

Cryptocurrencies still have yet to reach a place where more people use it regularly or even have a little bit within their digital wallets. As such, there is massive potential within the sector, but there’s also risks of immaterial adoption over time. A lack of adoption would mean that there’s significant activity and price action in the present without anything to show for it.

Lower Liquidity Markets

Low liquidity can mean high volatility.

The cryptocurrency sector has lower liquidity when compared to stocks and bonds because it is new and due to the mechanics present therein. Now, liquidity is important because you want to buy and sell digital assets without any concerns in any period, during good times and bad times. The larger the participation of market participants regularly, the better it is for everyone involved.

Market participants do not appreciate low liquidity because they prefer to buy when they want and sell when they want. Lower liquidity markets means that volume is low, and you will have to wait to exit and enter positions until more participants are present. The next point here is that low liquidity marketplaces have the potential for massive asset inflation and deflation due to the lack of funds needed to move the markets.

Minimal liquidity coupled with minimal regulation, can be a matchstick for great distress. More people with bad intentions can enter the market and seek to gain from it by resorting to manipulation. Although, the industry has evolved from 2016 to 2020, where there is much more infrastructure present.

Profit Seeking

Profit seeking takes place on a significant level when we have emerging markets. This took place during steam engines, oil, telecom, and other new technologies and industries.

But people are also seeking to preserve their value as more countries in Europe, and elsewhere have lower interest rate bond offerings, and minimal interest rate reception on bank savings. As such, they seek yield elsewhere, and bitcoin is one of these areas that they are placing money into so they can gain more value.

More profit seeking speculators push up the price and push it down depending on market sentiment. That is why you can have chaos and volatility in digital assets. The market sees to value bitcoin and other assets through price discovery, but that may not take place effectively when people are driven by optimism in the early stages.

Speculation, instability, and volatility go hand in hand.

Political and Economic Turmoil Effects

You might have noticed a wide variety of minds that have invested in the digital asset sector. These minds come from the highest forms of finance and still gravitate to bitcoin. Many of these people come from the macro investing industry and find it an intriguing asset that serves as an inflation hedge, non-correlated, and one with massive potential as currencies break down in various parts of the world.

Political

For instance, the United States dollar serves as the reserve currency of the world. When the rest of the world faces turmoil, the United States is present to do its part and serve as the last resort’s asset. Indeed, many people buy dollars when their country seems fiscally irresponsible.

But there’s a problem with the United States that started before the 2008 crisis but accelerated further. The economy is not as strong as it once was, 2019 and 2020 GDP slowed down and all this while large levels of debt in the public and private sector pose problems in the present and in the future.

Elements that Accelerate

The element of COVID-19, a pandemic that would start in 2019 and then progress into 2020 has caused a slowing of economic growth that poses even further problems for returns, employment, and wages. The United States is also seeming as if it is breaking down from a currency and economic standpoint.

At the same time, the Bank of England via Mark Carney, and others noted in 2019 that it might be a good idea to shift away from the USD as the global reserve as it causes economic instability for other countries. Specifically, the old world order with the USD at the center does not seem viable going into the future. Carney stated in 2019 that it might be wise to create a digital currency that central banks can collectively power.

He called for it because he saw that the United States has a debt level of over $20.5 trillion.

COVID-19 marks an intriguing point in history as it accelerates the future with the breakdown of physical spaces and virtual domains’ growth. A shift that in itself is causing strife and unrest due to lack of jobs and other issues in 2020. The virus’ stimulus and response should bring about more change, higher inflation, and other issues from 2020-2030.

A pressing problem that COVID-19 did cause was nations were forced to decrease their interbank lending rates to close to zero. Central banks would also conduct actions such as purchasing government bond assets and injecting liquidity into financial markets to make sure all assets stayed afloat.

A mainstay of the COVID-19 era was that of significant uncertainty and that would drive more interest in alternative asset classes. Experts in the COVID-19 era did depict inflation in some contexts, deflation in other contexts, and debasement of fiat currencies to service debt positions.

Volatility is present in these situations because different economic and political impacts can be a great boon to bitcoin or a negative depending on how traditional assets, reserve currencies, and other paradigms take place. As such builders, speculators, and other parties within the cryptocurrency domain watch news about politics, central bank adjustments, and other components that affect the economy to calculate volatility.

Hopefully you can see why people gravitate to cryptocurrencies and why the can be complex instruments.

Bitcoin in the Lead

It is also crucial to note that bitcoin is the best cryptocurrency because of its mission and the way it came into the world. For instance, bitcoin is the only digital asset that came about with the broadest and most earth-shattering mission.

As noted above, the mission is to disintermediate governmental and third party control from the aspect of money. As such, bitcoin did not make an initial coin offering; you do not know who the founders are and who to prosecute, and you had an organic growth and support for the coin over time. It would lead the way and become a respected coin because it came about and created an industry. Further, it is different because it helped to educate people on why decentralization matters and made waves in specific communities from the very start.

We know that bitcoin has a few critical characteristics that differentiate it from others. The coin is decentralized from a large standpoint as this is true with governance and the coin generation mechanism as well. It solved the double-spend problem. It is the most liquid of digital assets and serves as a great investment vehicle due to meeting many narratives.

Again, it is peer to peer, and many have used its open-source base to launch their own projects. Of course, the other compelling point is that you can send value to anyone within the world, and one bitcoin is one bitcoin.

Thus events that relate specifically to bitcoin can move the cryptocurrency markets. They have done so in the past and will likely do so in the future as bitcoin serves as a reliable asset in many regards. Bitcoin related volatility is a critical factor in the digital asset realm.

Volatility in Crypto: Positive or Negative?

The simple answer is that volatility just is a fact of life. It occurs because people have faith and others do not. Those that are pessimistic push back against optimism and sell assets, those that are optimistic will buy and hold.

Volatility is something that tells you something is happening, and the sooner you find out what it is, the closer you are to making critical decisions. Volatility lets you know to look deeply at the system and make decisions. Is the volatility present because of an existential threat or otherwise? Find the answers and position yourself accordingly in these times.

Always ask yourself how much risk you would like to take on when entering markets, the sooner you have your answer, the more decisions you can take with clarity. If lower risk, allocate less to crypto and more to bond alternatives, gold, or stocks. Cryptocurrency speculators are risk-on thinkers and doers.

If you are not a big risk-taker, only place a small portion of value into cryptocurrencies.

How Do We Measure Volatility?

You can measure volatility in the cryptocurrency sector in three ways:

• Bitcoin Volatility Index and standard deviation where the higher the standard deviation, the higher the volatility.
• Bollinger Bands
• General price deviation visibility

If you are a smart investor, you will plan for volatility and conduct risk management.

Risk Management in Your Crypto Portfolio

Here are the different ways to manage risk in your crypto portfolio.

Assess

The first action you should take is to conduct overall assessments of your different cryptocurrency assets. For instance, you must look at the downside and the potential upside as well. Look at your investment goals, how long you want to be in the markets, and the level of risk you would like to take over time. As you stay disciplined, you understand how to use volatility to your advantage without taking on significant risk.

You can do so by assessing yourself, the market, the asset, and overall goals.

Digital assets will find themselves with more volatility as investors expect more value from this emerging asset class. Further, they revel in volatility because they know that when the markets start rocking back and forth, they will generate significant value if they know what they are doing. For example, remember in 2017, when you saw bitcoin start at $1,000 before it went to $21,000 in early 2018.

Now, if you are interested in much more returns over a short period of time, you are likely to want to invest in volatile crypto. At the same time, you understand that you may lose a portion or all of your money in the markets during highly volatile times.

If you want to minimize volatility, you may want to invest in assets that have lower volatility in the digital asset class like stablecoins. Always assess for your risk tolerance, your time horizon, and your level of desired returns.

You can assess the potential by studying the past, the value, and the asset’s current drivers.

Diversify Your Portfolio

The idea is to minimize significant risk and control volatility by looking at your specific assets and then sizing it correctly. You can maximize the volatility in some assets and then add others that are calmer and add some balance to your portfolio. In a traditional portfolio, bonds or bond replacements can curb volatility. If your stocks were to go down, then the bonds would offset problems.

In crypto, if you hold bitcoin, ethereum, and a few others, you know these can move up quickly and go down potentially downward. What you must do is purchase some stable assets or those that will provide value in other regards.

Have a Strategy

Yes, you must have a strategy, even in cryptocurrency. You can do so by looking at what others are doing and understanding their thesis. Further, you can copy them or incorporate their ideas with your own. Forming a strategy will depend on your goals, risk tolerance, and time horizon. The best investor will always look for the strategy that works well with the goals that they have at the present moment.

Pay Attention to the Short Term but Prioritize Long-Term

Remember that the idea is to always look for the long-term returns by minimizing the potential for loss. If you lose 50% of your money, you need to generate a 100% just to breakeven. That is why chasing short term movements can burn your money and break your portfolio leading to sleepless nights.

That is why you must have capital that will be for the maximization of volatility gains and other capital that is for long term preservation and generation. Those assets that are strong, robust, and generally healthy that might decline in the short term, if it has value, will grow over the long term.

The first rule is to always never lose money because it is much easier to make money than without money. When you approach the markets, it is always looking at it from a (never lose money) standpoint.

Dollar-Cost Averaging Utilization

If you dollar cost average for the long-term, you will be able to ride the negative and the positive while balancing your asset purchases. That way, you must always think about buying units for long term value first, before thinking about the quick short term gains. If you are thinking ten years out, volatility in the short term doesn’t matter; you buy the general amount either way.

Volatility Maximization

Hire your cryptocurrency assets as if they are employees. If they are good employees, they will work for you and will earn their spot. But if they become slackers and don’t do their job, fire them. Volatility is great, but you must always look at it from the lens of how are the assets doing now? What is the price variance to value? As such, you can look at derivatives and other asset instruments that can help you manage your risk and optimize gains through volatility.

Crucial Takeaways

• Volatility will give you money and take your money. It all depends on how you use it and implement it.
• You must think differently in times of volatility to generate significant value.
• The higher the volatility, the greater the price movement upward or downward in a compressed time frame.
• You can measure risk by looking at the beta value or other components such as historical data.
• Do you want to head into volatility or balance your portfolio? What are your goals and strategies? If you know these components and strive, it will be tough to disappoint yourself.
• There’s many different factors the influence volatility in cryptocurrencies

Bitcoin and cryptocurrencies are phenomenal assets that come with volatility that you could use to your advantage if you plan appropriately. Have fun and good luck trading!