Cryptocurrency volatility: key aspects and risk management
Cryptocurrency volatility is one of the main features of digital assets that has a significant impact on both investment attractiveness and trading risks. It is the degree of variability in the price of a cryptocurrency over a certain period of time. It is important to realise that high volatility means both the possibility of high profits and the risk of large losses.
Factors affecting volatility:
Market capitalisation: Small and medium-sized cryptocurrencies are often more volatile than larger ones, such as Bitcoin or Ethereum, due to low liquidity and limited trading volume.
News events: News about regulation, hacker attacks, technological innovations or changes in major stock exchange listings can cause sharp price fluctuations.
Speculative nature: Many market participants invest in cryptocurrencies based on speculation rather than fundamental analyses, which increases volatility.
Institutional Investors: The emergence or exodus of large institutional investors can significantly affect the price of cryptocurrency.
Technological changes and forks: Protocol updates or blockchain branching can lead to uncertainty and price fluctuations.
Volatility management techniques:
Portfolio diversification: Investing in different cryptocurrencies and other assets can reduce the risk of loss due to the volatility of one asset.
Use of Stop Losses and Take Profits: Limiting losses and locking in profits when certain price levels are reached helps manage risk.
Hedging: The use of derivatives such as futures and options can protect against unfavourable price movements.
Long-term investments: Investing for the long term while ignoring short-term fluctuations can reduce the impact of volatility.
Technical Analysis: Identifying trends and patterns in price charts can help predict potential movements.
Risk Management: Determining risk tolerance and setting clear rules for position sizes and exit levels.
Tools for monitoring volatility:
VIX Index (Volatility Index): Although originally developed for the stock options market, similar tools exist for the crypto market.
ATR (Average True Range): An indicator reflecting the average range of price fluctuations over a certain period.
Bollinger Bands: Bollinger Bands show the deviations of the cryptocurrency price from the average, which can be an indicator of volatility.
How is volatility measured?
Volatility is measured using various methods that help investors and traders understand the level of price volatility in the cryptocurrency market. The following are the main ways to measure volatility:
Standard deviation:
It is a statistical tool that measures the degree of spread or dispersion of a series of values relative to their mean (arithmetic mean).
A high standard deviation indicates greater price volatility, while a low standard deviation indicates less volatility.
Average True Range (ATR):
ATR calculates the average value of the trading range over a certain period of time.
An increase in ATR indicates an increase in volatility, while a decrease in ATR indicates a decrease in volatility.
Volatility Index (VIX and its cryptocurrency counterparts):
Originally developed for the stock market, the VIX measures expected market volatility based on option prices.
There are similar tools for cryptocurrencies that use different metrics to determine expected volatility.
Historical volatility:
This method analyses past price changes to predict future volatility.
It is useful for assessing how the price of an asset has fluctuated over a certain period in the past.
Beta coefficient:
Beta shows how much the volatility of a security (or cryptocurrency) correlates to the overall volatility of the market.
A beta above 1 indicates that the asset is more volatile compared to the market, while a beta below 1 indicates less volatility.
Bollinger Bands:
It is a technical analyser that creates bands around the average price based on the standard deviation of the price.
Narrowing of the bands indicates low volatility, while their widening indicates high volatility.
Measuring volatility is critical for risk management and strategic trading planning. It allows investors to make more informed decisions based on their individual risk profile and investment objectives.
Volatility cycles
Volatility cycles in the context of cryptocurrencies reflect periods of high and low volatility in the prices of these assets. These cycles can be short, spanning hours or days, or longer, spanning weeks, months, and sometimes even years. Let's take a look at the key points related to volatility cycles in the world of cryptocurrencies:
What causes volatility cycles?
Market Sentiment: Overall investor sentiment can fluctuate from optimistic to pessimistic, causing changes in price.
News & Events: Regulatory announcements, technical updates, forks, and hacker attacks can cause dramatic price fluctuations.
Speculative Bubbles and Their Bursting: A rapid rise, which is often speculative, is followed by a correction that leads to a decline in volatility.
Technical Factors: Traders and investors may use certain technical indicators, and their widespread use can lead to self-confirming cycles.
Phases of volatility cycles:
Low Volatility: In this phase, prices may move gradually or get stuck in a sideways range. News and events have less effect on market prices.
Accumulation: During the accumulation period, wise investors begin to accumulate assets, still keeping volatility relatively low.
Increased Volatility: News or a change in sentiment can quickly increase volatility. Investors, reacting to the changes, begin to trade actively.
Peak Volatility: In this phase, prices can fluctuate rapidly and significantly. It is often due to traders' emotional reactions to market events or reaching price levels that cause mass closing of positions.
Decreasing Volatility: A period of high volatility is usually followed by a decrease as the market assimilates new information and prices stabilise.
Consolidation: High volatility is often followed by a period of consolidation where the asset price stabilises in a narrower range.
Managing volatility cycles:
Diversification: To protect against unexpected spikes in volatility, the portfolio should be diverse.
Technical Analysis: Using indicators and models to identify potential trends and turning points in volatility.
News Awareness: Following news and events helps to anticipate possible changes in volatility.
Risk Management: Applying risk management strategies such as setting stop losses and using only a portion of capital for speculative trades.
Understanding cryptocurrency volatility and using various strategies and tools to manage and monitor it can significantly improve trading results and help make informed investment decisions. It is important to remember that no strategy can completely eliminate the risks associated with volatility, but they can help to minimise potential losses and optimise the potential for gains.
