Understanding Volatility in Crypto: A Comprehensive Guide
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?
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:
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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 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 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 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.
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1 年Well done
Head of Economics Department | Assistant Professor | Economic Crime & Fraud Prevention | Digital Economy | Certified Trainer | International Speaker | Fulbright Scholarship Awarded- Temple University, USA.
1 年It's important to note that while volatility may pose challenges, it is an inherent characteristic of emerging and disruptive markets. As the crypto industry continues to evolve, efforts to address volatility, enhance market stability, and build robust infrastructure will contribute to its long-term viability and broader adoption. Ultimately, understanding and managing volatility is essential for market participants, regulators, and businesses to foster a sustainable and resilient crypto ecosystem.