The 2018 market crash serves as a hard lesson for many cryptocurrency investors on the extreme volatility of cryptocurrencies. It’s true the cryptocurrency market has been volatile from the very beginning, but the last two years have been a particularly wild ride with people making millions on the big upswings and people losing almost all their investments in the sudden market downturns. Within this period, the price of bitcoin and other cryptocurrencies witnessed vigorous fluctuations from end to end, leading many to conclude that cryptocurrencies are a highly unstable market full of speculation and uncertainty.
In the case of bitcoin, the price rose from $700 in January 2017 to almost $20,000 in December 2017. By February 2018, however, bitcoin price was at $6,200. Like a domino, the prices of other crypto assets like ethereum and litecoin followed suit and took a nosedive. Fast forward to 2019 and bitcoin’s price seems to have recovered and even broke the $10k mark back in June. Still, the volatility persists and as the time of writing, bitcoin is trading at $9,499.
What is the reason for these erratic price fluctuations and what kind of trading opportunities do they provide for beginners and professional investors alike? By understanding cryptocurrency volatility, you can learn to be a more effective trader. CoinFalcon explores this important market concept and how it is an integral component of the cryptocurrency market.
What Is Volatility?
In traditional finance, volatility is the statistical measure of the dispersion of an asset’s price. In simplest terms, it describes the extent to which the price of an asset fluctuates over time. An investment is considered volatile if its prices move aggressively up or down daily, which is the case with cryptocurrency trading.
Why is the Cryptocurrency Market so Volatile?
There are multiple reasons that contribute to the highly volatile and unstable environment of this asset class. These include:
1. Cryptocurrency is still an emerging market
Cryptocurrencies have enjoyed a lot of media attention over the years, but the size of the market is still minute compared to gold bullion and fiat currencies. Even at its peak, the cryptocurrency market was only around $800 billion, which is basically loose change compared to the total value of the gold market at over $7.5 trillion and the US stock market at around $28 trillion. This means that smaller forces can have a larger effect on the price of cryptocurrencies. For example, if an institutional investor decided to sell $300 million in gold, it would barely create a ripple in the price of gold, but If the same happened to bitcoin or ethereum, that amount can be enough to destabilize the whole market and send the price crashing.
2. Cryptocurrency is not a commodity
Most cryptocurrencies like bitcoin and litecoin are purely digital assets without any physical commodity or currency backing them. This means that their price is subject to the laws of supply and demand. However, since the supply of many of these cryptocurrencies like bitcoin is fixed, the price becomes dependent on how many people want to buy bitcoin right now. In addition, since there is no physical asset to back their value or governments to enforce their use as a currency, then the value of cryptocurrencies is backed entirely by faith. Unfortunately, this faith can be quite fickle and if people no longer believe that this value will hold or continue to rise, then they’ll likely sell, which in turn, reduces the price and convinces others to dump their crypto assets too.
3. Lack of institutional capital
While it is undeniable that some pretty impressive hedge funds, venture capital companies, and high net-worth individuals are huge fans of cryptocurrencies, most institutional investors are still on the sidelines along with their considerable capital. Institutional capital comes in many different forms, such as a mutual fund buying on behalf of their investors for the long term or a large enough trading desk with the potential to introduce greater efficiency and soften market volatility. As of the time of writing, however, there is limited momentum on crypto ETFs and mutual funds.
One reason for this is that unlike other markets like real estate or the stock market, the entry barriers into cryptocurrency trading and investing are not as stringent. You don’t need a trading license or have a minimum capital amount requirement to invest. All you need is a few bucks and an internet connection to start trading instantly. This may be appealing to amateur and individual traders around the world, but not to institutional investors.
4. Media hype
You already know that the cryptocurrency market is beleaguered with tons of speculation and media hype has a massive impact on where the prices go. Investors and speculators are constantly eyeing the headlines for the next big news story that will propel the market or crash it. Eventually, when something does emerge, it becomes a race to buy or sell and those who are able to react fastest get to profit the most, while the slowest tends to lose the most. This mad rush fueled by media stories only contributes to the market volatility. Plus, it doesn’t help that many of these cryptocurrency investors and enthusiasts get their news from not so credible outlets.
5. Unregulated Markets
Due to the complexity and the difficulty in regulating an open-source and decentralized technology, the cryptocurrency market remains largely unregulated. It’s true that cryptocurrency has become a worldwide phenomenon and many governments are going all out to clamp down on the industry, but it’s safe to say that regulation is still in its early days. With such limited regulation comes an influx of bad actors that can manipulate the markets, which in turn, introduces volatility and discourages institutional investment. These bad actors can make large orders with the intent of manipulating the market and cause sharp fluctuations.
There have been frequent numerous reports on the entities explicitly making moves to destabilize the cryptocurrency market, such as a coordinated pump-and-dump scheme and the manipulation of trading volume by cryptocurrency exchanges. Given that the cryptocurrency market is easily moved by news and sentiments, these reports only induce panic and will lead to even more chaos and volatility.
Summing it up
All these factors combine to push the price of cryptocurrencies in seemingly random directions and at random time intervals. Time and time again, experts have been shown to be wrong about predicting the crypto market, and that probably won’t change any time soon. However, understanding the fact that the market is so quick to change can help you be prepared to identify your risk appetite and make informed cryptocurrency investment decisions.
Understanding the Interplay between Volatility and Risk
Volatility in the cryptocurrency sphere is a vital concept to understand because it measures risks. As a bitcoin trader or investor, understanding your risk tolerance is always the first step before engaging in any form of investment. Of course, the level of risks that you choose to undertake is highly correlated to the potential returns that you would acquire. Simply put, a higher risk investment is associated with a greater probability of generating higher returns while a low-risk investment would yield a lower rate of return. In the finance world, this is known as the risk-return trade-off.
Cryptocurrencies fall under the high risk - high return category; it can give you a significant rate of returns but conversely, you must also be prepared for the possibility of a huge loss. One proven way to mitigate this risk level is to understand the factors that influence the price of digital currencies and learn how to read the crypto market.
By educating yourself and staying informed, you can take advantage of the market’s volatility and use it to your advantage.
Will this volatility ever decrease?
While there are still lots of speculations surrounding cryptocurrencies, having a greater diversity of investors and a more mature outlook on the market can go a long way in decreasing the current level of volatility. Also, as merchants find more accessible ways of accepting cryptocurrency and the technology behind transactions continues to improve, we can start to expect higher utility value in crypto investments. Not only will this lower volatility, but can also lead to a gradual but steady rise in the value of the cryptocurrency market as a whole, giving way to long-term holders just like the stock market.