When we hear the word volatility regarding traditional financial markets, we tend to think of extreme up and down swings, within an extremely short period. That's what the VIX (Volatility Index) measures, but it's not what this article discusses.
So instead, this article will discuss volatility in the cryptocurrency market — specifically when it comes to fluctuations in the value of popular cryptocurrencies and how they can impact your investment strategies.
What Is Volatility?
Volatility is a measure of how much an asset's price has moved up or down over time. In general, the more volatile an asset is, the riskier it is as an investment — and the greater the potential for bigger returns or higher losses over shorter time frames than relatively less volatile assets.
Cryptocurrencies, a younger asset class, are usually seen as volatile, with the potential for big up-and-down swings over shorter periods. Likewise, companies are said to have a wide spectrum of volatility, ranging from the relative steadiness of large-cap stocks to the frequently volatile penny stocks. On the other hand, bonds are considered a lower-volatility asset class with fewer spectacular up-and-down movements.
Volatility In Crypto Markets
As in conventional markets, volatility is an essential risk indicator in cryptocurrency markets. Cryptocurrencies are significantly more volatile than most other asset classes because of their digital origin, low regulation, and tiny market size.
This increased volatility is partly to blame for the surge in interest in cryptocurrency investment, as it enabled some investors to make huge profits quickly. However, long-term volatility in cryptocurrency markets is projected to reduce due to growing acceptance, market expansion, and increased regulation.
Investors have been more interested in monitoring the volatility of cryptocurrency markets as they have matured. As a result, certain markets now have volatility indices.
What Is The 'Crypto Volatility Index'
The Crypto Volatility Index was developed and launched in January 2021. A decentralized volatility index (VIX) for cryptocurrency allows people to protect themselves against market volatility and short-term loss.
For those unfamiliar with the term, the VIX is an indicator that measures stock market volatility based on the implied volatility of S&P 500 Index options; it is also known as the Market Fear Index. Similarly, the CVI assists users in tracking and trading the 30-day implied volatility of Ether (ETH) and Bitcoin (BTC) by employing the Black-Scholes capital asset pricing model to create an index between 0 and 200.
Black-Scholes is a pricing model that uses six factors to estimate the fair price or theoretical value of a call or put option: volatility, option type, underlying stock price, period, strike price, and the risk-free rate. The CVI is calculated by constructing a decentralized volatility index using cryptocurrency option prices and examining the market's anticipation of future volatility. Traders can use the index to speculate or hedge their portfolio if they believe cryptocurrency volatility will rise.
As previously stated, the index can swing between 0 and 200. The market's greatest volatility is 200, while 0 indicates little volatility. When the values of BTC and ETH fall significantly, the index rises in the opposite direction.
Key Reasons For Crypto Volatility
News: The value of cryptocurrencies is affected by the news. They rise when there is good news and fall when there is bad news. Stories about government control, international events, and illegal activities are examples.
However, the news is not always as simple as good vs. terrible. For example, last year, El Salvador made bitcoin a legal tender. As a result, bitcoin values decreased even though a new country was making crypto mainstream. In addition, many investors were concerned that El Salvador's weak economy might weigh on the value of Bitcoin.
Apparent Value: When bitcoin traders believe cryptocurrency values to be lower, they sell, lowering the price. Bitcoin and other cryptocurrencies, like gold, are typically measured in terms of fiat money (like the US Dollar). Therefore, the current value may fall if the asset's future worth is unknown.
Tax Regulations: The United States has hinted at more cryptocurrency laws. Cryptocurrency is now taxed as a property asset, meaning dealers must record the coin's market value at the time of each transaction. They are also required to pay capital gains taxes. One of the main reasons cryptocurrencies are so volatile is the fear of regulation's detrimental influence on them.
Whales: For many cryptocurrencies, one or a few investors control a significant portion of the coins. These people are known as whales. Whales that maintain their positions for an extended period can make the market turbulent by reducing the liquidity of the asset. Meanwhile, whales that sell a large amount of their cryptocurrency all at once might cause the market value to fall.
Volatility in the crypto market is quite paradoxical because as much as it predisposes investors to risk, volatility is more of a friend than an enemy. When exploited properly, the volatile nature of the crypto market will ensure that you make exponential profits within a short period. Hence, being abreast of information, helps the early investors exploit volatility to make exponential profits.