What is volatility?

Investors are often warned that cryptocurrencies are highly volatile, especially when compared to other tradable assets like stocks and bonds. But what exactly does that mean, and is it really such a bad thing? That all depends on what kind of investor you are, but either way, it is helpful to understand what volatility is before you start investing.

In this AAG Academy guide, we’ll explain volatility in detail, and look at how it’s measured in the cryptocurrency industry. We’ll also cover how volatility affects cryptocurrency markets and prices, and how it can be reduced.

What is volatility in cryptocurrency?

Volatility refers to how quickly and by how much the value of an asset changes over time. An asset that’s highly volatile tends to see large price fluctuations on a regular basis, while an asset that is not very volatile tends to see much smaller price changes. It’s important to note, however, that every tradable asset undergoes fluctuations to some degree on a constant basis.

Volatility is an important measure of risk no matter what you might be trading or investing in, but it is particularly critical in cryptocurrency, which is far more volatile than other asset classes. For instance, the average daily price change for stocks is -1% to +1%, but for cryptocurrencies like Bitcoin, it is regularly -5% to +5% — and it is not uncommon for it to be even greater than that.

Smaller, less established cryptocurrencies typically see even bigger price swings on a regular basis, making them even more volatile. There are many reasons for this, including the fact that they are completely digital assets, they are not regulated, and because the cryptocurrency market simply isn’t as large as those for things like stocks and bonds.

The good news is that there are now reliable volatility indexes for the biggest and most popular cryptocurrencies on the market, so you should be able to find accurate measurements for almost all of the projects you may want to invest in. And this is certainly recommended if you’re a sensible investor who is keen to minimize their exposure to risk as much as possible.

How is volatility measured?

It is difficult to predict the future volatility — officially referred to as “implied volatility” — of any asset, especially cryptocurrencies. As a result, when we measure volatility, we mostly focus on “historical volatility,” or how prices of a particular asset have changed over time. There are two common ways of doing this, which are:

Standard deviation
This method measures the dispersion of a dataset relative to its mean. In other words, it tells us how widely an asset’s price has diverged from its historical average. A standard deviation close to zero indicates low volatility, or that the asset’s price does not fluctuate significantly. A high or low standard deviation indicates greater volatility.

This is the method employed by most cryptocurrency volatility indexes, such as the Bitcoin Volatility Index, which uses 30- and 60-day preceding price windows.

Beta
The beta method allows us to measure the volatility of one asset in relation to the overall market. It’s great for determining whether one cryptocurrency is more volatile than others, or whether it’s more or less in line with the average. Most cryptocurrencies tend to follow Bitcoin’s price changes, but some have a tendency to vary even more widely.

It’s also worth noting that you can check the volatility of a cryptocurrency at a glance by simply looking at its price chart. Although this isn’t as accurate as the methods outlined above, seeing how an asset’s price changes and how frequent those changes are over a prolonged period of time, such as six months to several years, can be a good indicator of how volatile it is.

How does crypto volatility affect markets and prices?

In addition to relatively substantial and more frequent price swings, as we’ve touched on above, volatility has a number of other impacts on the cryptocurrency market. One of the biggest is that it affects market sentiment, or how investors feel and act. The higher volatility of crypto means that investors often harbor greater uncertainty or more anxiety over their decision making.

Some investors still avoid cryptocurrency or don’t trade it as often as other assets as a result of its volatility, which can lead to a decrease in demand and prices. In addition, this can contribute to lower liquidity, particularly during times of high volatility when investors are especially worried about putting their capital into cryptocurrencies.

All of these factors have contributed to cryptocurrency’s slow adoption and made merchants hesitant to accept digital assets as a form of payment. The hope is that this will change in the future as cryptocurrency becomes more widespread — and with the takeoff of Web3, which is built around cryptocurrency, blockchain technology, and decentralization.

Some investors like that cryptocurrency is highly volatile because it creates the possibility of higher returns. The bigger the value fluctuations are for a particular asset, the greater the opportunity to earn a substantial profit in a short space of time. This is why lots of traders “buy the dip” when a cryptocurrency is down; they are hopeful its rise will be just as significant.

How can crypto volatility be reduced?

It is likely that the level of volatility in cryptocurrency will naturally decrease over time as the market grows in size and the adoption and support of digital assets grows. There’s also a chance that, in the future, cryptocurrency will be regulated. While this will bring some downsides, it may also make digital assets a lot less volatile than they have been in the past.

It’s also worth noting that there are trading strategies to reduce volatility, such as dollar cost averaging and other long-term tactics. Some investors also use the Crypto Volatility Index (CVI) to hedge against market volatility and impermanent loss. When the price of BTC and ETH drop, the value of the CVI token goes in the opposite direction.

In addition, there are cryptocurrencies that are a lot less volatile than others, such as stablecoins, which have a price pegged to a reserve asset like the U.S. dollar or the euro.

References

• What is volatility
• Volatility
• What is stock market volatility
• Simplified measuring interpreting volatility