High market volatility has become a defining feature of cryptocurrencies. Wild price swings, which can result in devastating losses and substantial gains, make the crypto market a difficult place for the faint-hearted.
Crypto investors need to be agile and adaptive to the ever-changing market forces.
This article will help you understand the factors behind price fluctuations and learn about various risk management strategies that investors use to navigate through the uncertainties of the crypto market.
What Is Crypto Market Volatility?
Volatility is the measure of an asset’s liability to change rapidly in value. The crypto market is synonymous with volatility because its prices tend to rise and fall tremendously quickly.
Not all volatility is the same in the crypto market. It heavily depends on the asset. For example, bitcoin’s volatility is usually much lower than a newly-launched meme coin. Generally, the more volatile the asset, the riskier the investment. A highly volatile cryptocurrency has the potential to produce higher returns or losses over a less volatile token.
Since cryptocurrencies have only existed for just over a decade and it’s still a fledgling market compared to traditional markets, it experiences high volatility. In comparison, the stock market has a wide range of volatility where well-established large-cap stocks like Apple (AAPL) and Microsoft (MSFT) behave less erratically than small-cap tech stocks. Bonds, for example, are known for their extremely low volatility, which attracts conservative investors looking to prioritize investment safety over returns.
Beta (β) is the unit used to measure market volatility. The beta of two or more assets can be compared to identify the riskier investment.
Here is an example.
Equity fund managers compare the beta of a stock against a benchmark – like the beta of the S&P 500, an index that tracks the price of the 500 biggest companies in the U.S.
In the crypto sector, BTC is considered the benchmark as it is the oldest crypto in the world.
Factors Affecting Crypto Market Volatility
Risk asset markets are heavily influenced by two human emotions – fear and greed. Positive news about a cryptocurrency can trigger bullish trends as investors speculate on future profits. We have seen endorsements from celebrities like Elon Musk as well as established brands like Meta (META) and Disney (DIS) helping fuel token price surges.
On the other hand, negative news about a project or the crypto sector can spark fear in the market. Risk aversiveness may prompt investors to dump their tokens at the first sight of trouble, increasing market volatility.
You can check the Crypto Fear & Greed Index to analyze one tracker that attempts to generalize the current market sentiment. Traders look to it to time their market entry and exit. Extreme fear can indicate an oversold market, suggesting that the bottom may be in soon, while extreme greed can indicate an overbought market, indicating that a fall in crypto prices may be next.
Note that the market is uncertain, and these tools are not always right. It is recommended to conduct thorough research, seek advice from a qualified financial advisor, and consider one’s risk tolerance and financial situation before making any investment.
2. Supply and Demand
The market is all about supply and demand. High demand for a crypto token will result in a spike in its price. Since everybody wants a piece of that crypto, the market will be willing to pay a premium for the in-demand item.
Subsequently, when the supply of a token increases, the price of the token is more likely to fall. Token supply can increase due to its in-built tokenomics, scheduled release of tokens, end of investor vesting period, market selling, and more.
The dynamics of supply and demand are related to factors such as news, regulations, tokenomics, utility, and more.
Liquidity refers to the amount of liquid assets available in the market at a given time. A highly liquid market is easier to trade without paying high premiums because there is plenty of assets to go around.
A highly liquid market can result in low volatility as there is more of the asset available for trading at the market price.
Conversely, low liquidity conditions make the market susceptible to sudden price movements, as relatively small trades can lead to disproportionate price swings.
Tokenomics is the study of the supply, demand, distribution, and valuation of cryptocurrencies. It includes everything from the issuance and burn mechanism of a cryptocurrency to its utility and more.
Tokenomics affects market volatility as it direct can impact the supply of tokens. For example, the price of bitcoin tends to rise near its halving period. This is because, roughly every four years, the number of bitcoins emitted with each block is reduced by half.
The expectation of lower supply inspires and amplifies bullish trends.
The role that social media and mass media plays in crypto market volatility can’t be disregarded. The meme coin frenzy seen in 2023 as a result of intensive publicity and promotion is an example. The NFT market is particularly reliant on hype and social connections to onboard new buyers.
When there is any major piece of news on a cryptocurrency, the market is extremely quick to react and trade based on the information. This often leads to major swings as thousands of traders rush to enter their trades.
A crypto whale is someone who holds a lot of cryptocurrencies. If they hold enough, their trades could impact the entire market. There are whales for all kinds of assets, including BTC, ETH, DOGE, and even NFTs.
A whale buying or selling large swaths of tokens can result in massive price swings in either direction. This is amplified further because of the transparent nature of the blockchain. Crypto participants often track whale activities to try to predict short-term and long-term price trends. They may even look to mirror the whale’s trades as their investment strategy.
Macroeconomic factors like interest rates, inflation, and unemployment rates are becoming important crypto market drivers. There was a time when cryptocurrencies live in isolation, unaffected by traditional market forces.
As more institutional investors and corporations invest in the crypto market, the effects of macroeconomic forces become more prominent. These players constantly rejig their portfolios to be optimized for global economic conditions.
We saw this trend play out in the 2022 bear market, where cryptocurrencies became increasingly correlated with equity markets. Both markets fell as global central banks embarked on an interest rate hike cycle in order to fight rising inflation.
Investment Strategies to Help Protect Your Portfolio Against Crypto Market Volatility
Portfolio diversification is a simple and effective risk management strategy. You can spread your risk across various assets as well as cryptocurrencies and stablecoins so that a price drop in one token will not take down your entire portfolio.
Each token offers its own advantages. Bitcoin and ether are the two biggest cryptocurrencies in the world which tend to lead crypto market cycles. While stablecoins give investors a safe haven from fluctuating market prices. Decentralized finance (DeFi) coins like MKR and UNI provide utility other than payments like voting power.
Be careful with investing too much of your portfolio into cryptocurrencies, as the market often tends to move together.
A stop-loss order is an order that automatically sells cryptocurrency once it reaches a certain price. Traders can use stop-loss orders to ensure that losses are limited in case the price of the cryptocurrency falls.
One of the biggest benefits of using a stop-loss order is that it prevents emotion-driven decisions. Traders can instead be research-driven and set pre-determined selling prices to limit losses and book profits in volatile markets.
Dollar-Cost Averaging (DCA)
Another simple yet effective strategy is to dollar-cost average your crypto investments, where you invest a fixed amount at regular intervals to smooth out the impact of market volatility over time.
Dollar-cost averaging is beneficial for long-term investors as they will continue to invest whether the market is bearish or bullish. As long as the crypto investment is returning over a long period of time, it doesn’t matter whether the price falls or rises in the short or medium term.
Just like stop-loss order, dollar-cost averaging doesn’t suffer from the side effects of emotion-driven decisions. It’s important to note that dollar-cost averaging only works on assets that will continue to grow over time. A meme coin that may see a massive spike in the short term would likely be a poor choice to DCA into as it may not continue to perform well over time.
Financial derivative instruments like options, futures, and perpetual swap contracts are often used for hedging. These are instruments that allow traders to speculate on the underlying asset without owning it. Furthermore, the use of leverage in these instruments allows traders to gain more exposure beyond their available capital.
Here is an example of using an options contract for hedging. Let’s say you own 1,000 ETH tokens. You are aware of the bearish macroeconomic and regulatory market conditions, and you fear that the price of ETH may drop soon. You can hedge your portfolio against future losses by buying put option contracts.
Put option contracts give the holder the option to sell an underlying asset at a fixed price at a pre-determined price. Now if ETH is trading at $2,000 and you want to protect yourself against losses beyond 20%, you can buy a put option that grants you the option to sell your tokens at $1,600.
This is how many traditional financial institutions hedge their bets, but it can be complicated and easy to lose money if you don’t do it right. If you plan on using derivatives, it’s advisable to talk to a financial advisor and do in-depth research first.
A volatility index is an index that tracks market volatility. In U.S. equity markets, CBOE Volatility Index (VIX) tracks the volatility of the S&P 500 Index. The VIX index gains when there is a greater level of fear and uncertainty in the market. Equity investors use the VIX index to hedge against and profit from market volatility by buying its options contracts.
The crypto market has its own volatility index known as the Crypto Volatility Index. The index tracks the 30-day implied volatility of BTC and ETH. Crypto investors can use the CVI token, which is pegged to the Crypto Volatility Index, to hedge against market volatility.
Crypto market volatility presents both opportunities and risks for investors. Understanding the causes behind market fluctuations is crucial for making sound investment decisions. By adopting risk management strategies and diversifying their portfolios, investors can navigate the crypto market with greater confidence and enhance their chances of success.