Volatility is the amount by which the price of a given item has increased or decreased over time. In general, the more volatile an asset is, the riskier it is as an investment, since it has the potential to produce either greater returns or greater losses over shorter time periods than comparably less volatile assets.
As a relatively new asset class, cryptocurrencies are typically seen as volatile, having the potential for big price swings over shorter time periods. There is a broad range of volatility across stocks, from the relative stability of large-cap equities (such as Apple or Berkshire Hathaway) to the chaotic behaviour of “penny stocks.” Bonds, on the other hand, are regarded as a lower-volatility asset and often experience less pronounced upward and negative movements over longer time periods.
How is volatility measured?
When discussing volatility, individuals often refer to “historical volatility,” a statistic obtained from an examination of prices over a certain time period (often 30 days or a year). The prediction of future movements is referred to as “implied volatility,” and because no one can accurately predict the future, it is a less exact science (although it is the basis for widely used financial tools such as the Cboe Volatility Index, also known as the “fear index,” which predicts the next 30 days’ stock market volatility). Several approaches exist for quantifying volatility:
- You may utilise the beta approach, which evaluates the volatility of a stock compared to the market as a whole (the typical benchmark is the S&P 500).
- The standard deviation of an asset is a measure of how far its price has deviated from its historical mean.
Why is volatility important to understand?
Volatility is one of the major elements used to evaluate investment risk. Traditionally, investors assume a high degree of risk if they feel the possible gain is greater than the chance of incurring a loss. (Or their whole investment, as in the recent instance of high-risk hedge fund manager Bill Hwang, whose $20 billion fund vanished in two days.)
- Historically, individual investors have been urged to diversify their holdings within a given asset class in order to reduce risk. Investing in a basket of equities (or in an index fund) is a common investment technique. They may also match investments in more volatile asset classes, such as equities, with investments in less volatile asset classes, like as bonds, to decrease downside risk.
- As an asset class that is just a little more than a decade old, cryptocurrencies have had a series of sharp gains and subsequent declines, and are regarded as more volatile than equities. Nonetheless, greater trade volumes on Bitcoin (by far the largest cryptocurrency by market capitalization) and growing institutional involvement seem to be decreasing its volatility over time. Cryptocurrencies with smaller trading volumes or developing cryptoassets, such as DeFi tokens, tend to be more volatile; while dealing with these assets as a novice, it’s advisable to only risk what you can afford to lose.
- Positive or negative news coverage and profit reports that are better or worse than anticipated might cause volatility. Typically, abnormally large jumps in trade volume correlate to volatility. Extremely low volume (as seen with so-called penny stocks that do not trade on major exchanges or tiny cryptocurrencies) is often accompanied by extreme volatility.
Are there ways to reduce crypto volatility?
For some crypto investors, extreme volatility is appealing since it presents the potential for large profits. (And despite the fact that Bitcoin’s volatility seems to be decreasing, it sometimes fluctuates by double-digit percentages in a single week, enabling techniques such as “buying the dip.”)
There are solutions, such as dollar-cost averaging, available to investors with a lower risk tolerance for mitigating the negative effects of volatility. (Investors with longer-term plans who have solid reason to anticipate that a security will eventually appreciate over time should not be as concerned with short-term volatility.) Stablecoins, which include USD Coin and Dai, are cryptocurrencies meant to have minimal volatility and whose price is fixed to a reserve asset such as the U.S. dollar.
