Understanding the Basics: What is Volatility?

Volatility is an essential term for anyone involved in the realm of finance and investment, yet it is often shrouded in ambiguity. At its core, volatility refers to the degree of variation in the trading prices of securities, indicating the frequency and degree to which the price might increase or decrease for a set of returns.

These price movements are measured over certain periods—daily, monthly, and yearly—to provide a statistical view of a security’s dispersion of returns. In simple terms, the larger these price swings (upwards or downwards), the higher the level of volatility. Conversely, more minor price fluctuations translate into lower volatility.

Why does volatility matter to an investor, you might ask? The level of volatility exposes the amount of risk or uncertainty about the size of changes in a security’s value; a higher level of volatility means that a security’s value can potentially be spread out over a larger range of values. This means that the security price can change dramatically over a short period of time in either direction, leading to a higher potential for unexpected losses or gains.

A lower level of volatility, on the other hand, indicates that the value of a security does not fluctuate dramatically but rather changes at a consistent rate over a given period. For risk-averse investors, lower volatility is often more desirable. Understanding volatility provides a snapshot of the risks—the highs and lows your investment may experience—allowing you to make more informed decisions.

An example of low volatility (EUR/USD). The price in the last year moved in a range of 15%. \

And an asset with high volatility. (BTC/USD) moved in a range of 150% in the past year.

Historical Volatility Vs. Implied Volatility

As you venture deeper into the intricate world of volatility, two types emerge from the mist of financial jargon: Historical volatility and implied volatility.

Historical Volatility, in keeping with its name, focuses on the past. It is derived from the standard deviation or variance of the past price fluctuations of an asset. Historical volatility provides an objective measure of the direction and volatility of the market in the past by analyzing these changes over a specified period. As an experienced investor would confirm, however, past performance is not always indicative of future results. It is only a piece of the puzzle when trying to predict future price behavior.

Implied Volatility, conversely, peers into the crystal ball of the future. This type of volatility is derived from the current market price of an option. It reflects what the price of the security “implies” about the future volatility of the security. As implied volatility is forward-looking, it responds quickly to shifts in market sentiment and is therefore a crucial indicator of future market conditions.

Understanding the distinction between these two types of volatility is essential to developing a complete investment strategy. It assists investors in assessing potential risks and returns by balancing past market behavior with anticipated market behavior.

Exploring Volatility in Traditional Financial Markets

Now that we’ve taken a closer look at what volatility means and how it’s measured, let’s explore how it manifests in traditional financial markets.

Stock markets, one of the most commonly traded financial markets, offer ample evidence of volatility. For instance, during periods of financial crisis, stocks have been known to swing wildly in response to changing economic conditions. This volatility can create a sense of fear or excitement among investors, depending on their risk tolerance and investment strategies.

An example of high volatility during a Bank Crash early this year (Silvergate):

Forex markets, dealing with the exchange of currencies, also exhibit considerable volatility. Here, the value of a currency relative to another can change rapidly due to various factors including economic indicators, interest rate changes, geopolitical events, and even natural disasters. The 24/7 nature of the forex market also contributes to its high volatility.

Commodities, whether they’re precious metals like gold or silver, energy resources like oil and gas, or agricultural products like wheat or coffee, are also susceptible to volatility. Changes in supply and demand, political instability, weather or harvest yields, and economic policies can all result in significant price fluctuations.

The Effect of the Russia-Ukraine War on the Oil price:

Unraveling the Volatility in Cryptocurrency Market

As we transition from traditional markets to the world of cryptocurrencies, we find that volatility takes on an even more pronounced role. The cryptocurrency market is notoriously known for its high levels of volatility. One reason for the increased volatility in the crypto market is its relative infancy. Being a new market, it’s often subject to large price swings as investors are still trying to price the value of these digital assets accurately.

Another factor contributing to crypto market volatility is the lack of liquidity. Since the market is smaller compared to traditional financial markets, it can be more significantly impacted by individual buy and sell orders.

Moreover, cryptocurrencies are often subject to speculative trading, leading to rapid price changes. Media coverage (you can find very interesting research on this here), technological changes, regulatory news, and changes in sentiment all have a significant impact on cryptocurrency prices.

Chart of Bitcoin (BTC/USD) in the past 7 years, a change in price of over 35000%

Case Study: Volatility and Bitcoin

Bitcoin, the world’s first and most renowned cryptocurrency, is an excellent case study for understanding volatility in the crypto sphere. Since its inception, Bitcoin has experienced dramatic price swings, capturing the allure and apprehension of cryptocurrencies.

Historically, Bitcoin has exhibited high levels of volatility. For instance, in December 2017, Bitcoin’s price almost hit $20,000, only to drop below $3,500 a year later. By 2021, it had surged again, reaching new all-time highs, before experiencing significant retracements as of today, sitting around $30,000.

Such fluctuations can be attributed to several factors. Firstly, as with the wider crypto market, Bitcoin’s relative novelty and liquidity issues contribute to its volatility. Furthermore, speculation plays a significant role, with traders rushing to buy in anticipation of price rises or selling out of fear, leading to dramatic price shifts.

Another key factor is the influence of regulatory news on Bitcoin’s price. Announcements of regulatory crackdowns or endorsements of cryptocurrencies by governments or financial institutions have been known to cause sharp price movements. For example, when Elon Musk’s Tesla announced the acceptance of Bitcoin as payment, it resulted in a considerable uptick in its price.

Lastly, Bitcoin’s built-in scarcity (the total supply is capped at 21 million) also contributes to its volatility. Whenever there’s a surge in demand for Bitcoin, the price tends to increase significantly because there’s a limited supply.

Practical Tips for Managing Cryptocurrency Volatility

While volatility can present investment opportunities, it can also pose considerable risks. Therefore, having strategies to manage this volatility is critical, especially in the context of cryptocurrencies. One crucial strategy is portfolio diversification. By spreading investments across various assets, you can potentially offset losses in one with gains in another.

Source: https://www.americancentury.com/

Next, staying updated with market news and trends is key. This includes not just news about specific cryptocurrencies but also broader economic and regulatory developments that could impact the crypto market. We got you on this with our News Section, which you can find here.

Finally, adopting a long-term perspective can also be helpful. While cryptocurrencies can be highly volatile in the short term, many have shown substantial growth over the long term. As a result, investing with a long-term perspective and avoiding short-term price fluctuations could be a wise move.

The Future of Volatility in Cryptocurrency

As we look to the future, what might we expect regarding volatility in the cryptocurrency market? This is a complex question with many moving parts. However, there are a few trends and factors we can consider.

One influencing factor is the continued integration of cryptocurrencies into mainstream financial systems. As more traditional financial institutions adopt or invest in cryptocurrencies, we could see increased liquidity and potentially more stability.

However, on the other side, we have the unpredictable impact of regulations. As governments worldwide grapple with how to manage and legislate digital currencies, new laws and regulations could introduce additional volatility.

Finally, the rate of technological innovation and competition within the crypto space itself could also influence volatility. As new coins emerge and existing ones develop, shifts in market dynamics could create volatility.

Conclusion: Embracing Volatility in the Cryptocurrency Space

In the ever-evolving world of cryptocurrencies, volatility is not just a characteristic; it’s a constant companion. It can be a double-edged sword, presenting opportunities for high returns, while also carrying the potential for significant losses.

The key to navigating these choppy waters is understanding and managing risk. By understanding what volatility is and what influences it, you are better equipped to plan your investment strategies. By diversifying your portfolio, staying informed, and maintaining a long-term perspective, you can potentially turn volatility to your advantage.

Ultimately, volatility in the cryptocurrency market is not something to fear but to embrace, as it can open up opportunities for savvy investors willing to take calculated risks.