07 December 2022

Volatility in Crypto: Causes and Consequences

A look at the causes and consequences of the volatility seen in the cryptocurrency markets.

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Volatility in Crypto: Causes and Consequences

    Index

    What is Volatility?
    How Does Crypto Volatility Affect Investors?
    How Can You Protect Yourself Against Volatility
    Key Takeaways

With major black swan events now commonplace, asset prices have become more volatile than ever. Exchange insolvencies, crypto "bank" runs, and cascading liquidations have wreaked havoc on the crypto markets this year, particularly with billions of dollars of value wiped out — in some instances — overnight.

With rumors of insolvency and a liquidity crunch circling FTX, one of the largest cryptocurrency exchanges, it's essential to discuss volatility, how it works, and what it means for crypto markets.

What is Volatility?

Crypto volatility is the overall fluctuation in the prices of cryptocurrencies. Conceptually, crypto volatility is no different from any other asset volatility; however, historically, crypto assets have been much more volatile than other asset classes. In crypto, large price swings come and go like a fall breeze, making it difficult to predict what will happen next. And, when you couple that with the 24/7 trading that occurs on cryptocurrency exchanges, it can be a very daunting task to try and day trade or even swing trade cryptocurrencies.

Several factors contribute to crypto volatility. Some of these include:

  1. Regulation: Many cryptocurrencies are not yet regulated in most jurisdictions. This lack of regulation makes it easier for bad actors to manipulate prices, which can lead to large swings in the market.
  1. Liquidity: There is still relatively low liquidity in the crypto markets. Considering the tens of thousands of different cryptoassets, there aren't that many people trading them. Inferior liquidity leads to higher volatility as small trades can significantly impact prices.
  1. Sentiment: Cryptocurrencies are often driven by investor sentiment. Sentiment changes affect every asset class, but cryptocurrencies seem to be more susceptible to changes in investor sentiment.
  1. FOMO/FUD: Fear, Uncertainty, and Doubt (FUD) can lead to investors selling their assets en masse, causing prices to crash. Similarly, fear of missing out (FOMO) can lead to investors buying assets without fully understanding the risks, leading to sharp price increases.
  1. Hacks: Large-scale hacks of exchanges and wallets, smart contract exploits, and other vulnerabilities have stolen billions of dollars worth of crypto. Drastically affecting sentiment, these hacks also lead to large swings in prices.

How Does Crypto Volatility Affect Investors?

When the market is rushing, it's easy to get caught up in the moment and make impulsive decisions that you later regret. For example, you might buy a coin just because of it's rising price without researching the project or the team behind it.

On the other hand, when the market is crashing, it's easy to panic and sell your coins at a loss, even if the project is still sound and the team is still working hard.

In either case, your emotions are working against you, making rational decisions difficult. This is why it's essential to have a clear investment strategy before you start buying coins and to stick to that strategy no matter what the market does.

Historically, Bitcoin tends to be the least volatile cryptoasset during bear markets. This is because the vast majority of cryptoassets are technological experiments, many of which will fail. Bitcoin, on the other hand, is battle-tested and has been around for over ten years. Moreover, its relatively ample liquidity, well-known brand, and growing adoption give it the stability that other assets don't have.

Bitcoin is digital money and doesn't try to be anything else. With the lowest systemic risk, it is the most reliable store of value in the crypto space. This is why, during bear markets, Bitcoin becomes a haven for many investors, and its price fares the best against other cryptoassets.

How Can You Protect Yourself Against Volatility

There are a few ways to take advantage of crypto volatility. One way is to buy when the prices are low and sell when the prices are high — but that's easier said than done. No one's perfect, and it's tough to time the market accordingly.

Day trading, margin trading, and short selling are all strategies that can be used to take advantage of market volatility, but they're also very risky. While the gains can be enticing, the losses can be catastrophic, which is why these strategies are only suitable for experienced investors with a high tolerance for risk.

Another way to take advantage of market volatility is to dollar-cost average into your investments. This means regularly investing a fixed amount of money into an asset, regardless of the price. For example, you might invest $100 into Bitcoin every week. Over time, you will average your purchase price and won't need to worry about timing the market.

Holding stablecoins is another way to protect yourself from crypto volatility. Stablecoins are cryptocurrencies pegged to a stable asset, such as the US Dollar. During wild volatility swings, you can convert your crypto into a stablecoin and avoid losses. Then, when the market stabilizes, you can convert your stablecoins back into crypto.

However, most importantly, the best way to protect against the effects of volatility is to buy and hold for the long term.

Key Takeaways

  • Crypto volatility can be caused by several factors, including FUD, FOMO, hacks, sentiment changes, etc.
  • Volatility can be a good or bad thing, depending on how you view it. On the one hand, it can lead to significant losses. But on the other hand, it also provides opportunities for investors to make substantial gains.
  • The best way to protect yourself from volatility is to have a clear investment strategy according to your goals.
  • The buy-and-hold strategy is the most effective way to take advantage of market volatility. By buying and holding for the long term, you will weather the storm and come out ahead in the end.

This article is not financial advice. It is for educational purposes only. Investing in cryptoassets is risky, and you should always research before investing.

Please be aware that: Cryptocurrencies are unregulated in the UK; Cryptocurrencies are not protected under Financial Ombudsman Service or Financial Services Compensation Scheme (FSCS); Profits may be subject to capital gains tax; The value of investments can go down as well as up.

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