Investors take high risks when they decide to invest. One of the primary factors they consider when assessing investment risk is volatility.
Investors choose to take high risks if they believe that the potential return is greater than the possibility of losing some or all of the investment.
What is Volatility?
Volatility is a statistical measure of how much the price of an asset, security, or market index has increased or decreased over time. Generally, the higher the volatility of an asset, the riskier the investment. And, it offers higher returns or higher losses over a short period of time, in contrast to assets that are less volatile.
In the securities market, volatility usually means big swings either way. For example, when the stock market experiences increases and decreases of more than one percent over a long period of time, we refer to it as a volatile market. The volatility of an asset is the key factor to look at when pricing options contracts.
Furthermore, cryptocurrency is a relatively new asset class, so most people think it is volatile because it can increase or decrease significantly in a short period of time. People think that stocks have a wide range of levels of risk, from the relatively stable large-cap stocks to the often risky “penny stocks.” Bonds, on the other hand, are thought to be a lower-volatility asset because their prices go up and down less dramatically and over longer periods of time.
Understanding Volatility
A higher level of volatility indicates that a security’s price may fluctuate over a larger range of values. A lower level of volatility indicates that a security’s price fluctuates less frequently and tends to be more stable.
The standard deviation or variance between the returns on the same asset or market index is a common way to gauge volatility. Derived from past prices, historical volatility quantifies the degree of variation in an asset’s returns. This numerical value, expressed as a percentage, is devoid of any units.
Variance is a measure of the dispersion of returns around the mean of an asset in general. Whereas, volatility is a specific time-bound measure of that variance. Hence, we can report daily, weekly, monthly, and annualized volatility. Therefore, it is practical to consider volatility as the annualized standard deviation.
Why is it Important to Understand?
Traditionally, retail investors are usually told to diversify their investments across different types of assets as a way to reduce risk. A popular approach is to invest in a basket of stocks or an index fund instead of just a few. They may also pair investments in more risky asset classes, like stocks, with investments in less volatile asset classes, like bonds, to lower the chance of a loss.
Crypto has only been around for a little more than a decade. It has seen a series of sharp rises and falls and is thought to be more volatile than stocks. However, Bitcoin seems to be becoming less volatile over time as more people trade it and more institutions join in. Cryptocurrencies with low trade volumes or new crypto assets like DeFi tokens tend to be more volatile. If you’re just starting out, it’s best to only risk what you can afford to lose when trying out these assets.
Things like good or bad news coverage and company reports that are better or worse than expected can make volatility worse. Generally, volatility shows up as unusually high jumps in the volume of trades. Very low volume often accompanies high volatility, as observed in “penny stocks” that do not trade on major markets or smaller cryptocurrencies.
Factors that create Bitcoin volatility. Source: Investopedia
How to Calculate Volatility?
As we mentioned above, variance and standard deviation are used to calculate volatility. The standard deviation is the square root of the variance. Since volatility is a measure of changes over a certain amount of time, you just multiply the standard deviation by the square root of the number of periods in question. The formula used to calculate volatility is:
vol = σ√T
where:
v = volatility over some interval of time
σ =standard deviation of returns
T = number of periods in the time horizon
Other Measures
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- Beta (ꞵ) – The beta is another way to measure how volatile a stock is compared to the market as a whole. A beta measures the volatility of a security’s returns compared to the returns of a relevant benchmark, typically the S&P 500. For instance, based on price level, a stock with a beta of 1.1 has moved 110% for every 100% move in the benchmark. On the other hand, a stock with a beta of 0.9 has moved 90% for every 100% change in the underlying index.
- The Volatility Index (VIX) – is a numeric measure of broad market volatility. The Chicago Board Options Exchange created the VIX as a way to figure out how volatile the U.S. stock market is expected to be over 30 days. It is a good way to see how investors and traders think the markets or stocks will move in the future. If the VIX is high, it means the market is risky. Traders can also trade the VIX using different options and exchange-traded products, or they can use VIX values to price certain derivative products.
Volatility in Traditional Markets
Volatility is most talked about in the stock market, and because it is such an important part of assessing risk, traditional markets have established measures to possibly predict future levels of volatility. For example, VIX is used on the American stock market.
Volatility is usually associated with stocks, but it is also important in other traditional markets. In 2014, the CBOE introduced a new volatility index for 10-year US Treasury notes. This index measured the confidence of investors about the bond market and its risks. Even though there are a few standard tools to measure it, volatility is also a key component of figuring out what opportunities there are on the foreign exchange market.
Volatility in Crypto Markets
In crypto markets, volatility is an important measure of risk, just like in other markets. Cryptocurrencies have higher volatility than most types of investments because they are digital. In addition, there aren’t many regulations about cryptocurrencies right now, and the market is small.
This higher level of volatility is a reason why so many people are interested in investing in cryptocurrencies. It has helped investors get big returns in a short period of time. In the long term, the increased usage of cryptocurrency by a growing number of individuals, along with the implementation of additional regulations, may potentially lead to a decrease in volatility within cryptocurrency markets.
As we get used to the cryptocurrency industry, investors have become more interested in measuring volatility. Hence, some of the major cryptocurrencies now have volatility indexes. The Bitcoin Volatility Index (BVOL) is the most well-known, but there are also volatility indexes for Ethereum and Litecoin, among others.
Why are Cryptocurrencies So Volatile?
The main reason cryptocurrencies are volatile is because they are new to the world. As every other new concept, cryptocurrencies also take time to adopt and accept. Even though volatility is getting in the way of buyers, cryptocurrencies are catching the attention of many investments. Without further ado, here are some of the causes of high volatility in cryptocurrencies:
Price Discovery Stage
The asset class, the market, and investors are still finding their place, so price discovery is still in the initial stages. In recent years, cryptocurrencies have acquired global prominence, but as an asset class, they are not as widely accepted as traditional assets (equity or gold). Increasing acceptance and market maturity go hand in hand.
For instance, when Tesla announced that cryptocurrencies would not be recognized as a form of payment, Bitcoin’s value decreased. Whereas, when its CEO, Elon Musk, wrote in a tweet, “Doge,” the value of Dogecoin increased. Such influential events contribute to the volatility, just as when a prominent investor purchases shares of a particular company, the prices of those shares tend to rise.
Given the lack of knowledge and regulations, trading is currently highly speculative. Investors bet on whether prices will go up or down. These speculative bets cause a sudden inflow or outflow of money, which makes the market very volatile.
No Controlling Agency
We are used with fiat money, equity, and bonds that are controlled and regulated by agencies, governments, or banks. However, cryptocurrencies, by nature, are not controlled by any entity. This anonymity is a two-way end, it either attracts investors or makes them skeptical.
The Sentiment Factor
When the crypto industry becomes more popular and accepted, more investors will be able to understand what makes them move. Until then, a lot of the movement is based on speculation, since buyers buy and sell based on how they feel (sentiment).
Even people who are interested in cryptos in the long term do so because they think the asset class will be more accepted. For example, Elon Musk said that he owned Dogecoin because a lot of Tesla and SpaceX workers also owned it.
Limited Supply and Major Holdings
Unlike regular money, some cryptos, like Bitcoin, have limited supply. Bitcoin has a limited supply of 21 million. But it is one of the most popular cryptocurrencies; hence, demand and supply come into play. For example, the maximum supply of Litecoin is set at 84 million, while Chainlink has a maximum supply of 1 billion. Additionally, as cryptocurrency is a digital asset, its price is determined by the interplay of supply and demand forces.
Types of Volatility
Implied Volatility (IV)
One of the most important measures for options traders is IV, which is also called projected volatility. IV lets traders determine how volatile the market will be in the future. With this concept, traders can also calculate probability. One important thing to remember is that it’s not science, so it can’t tell you how the market will move in the future.
In contrast to historical volatility, IV is based on the price of an option and shows volatility expectations. Because it is assumed, traders can’t use past performance to predict how it will do in the future. Instead, they have to estimate how likely it is the option on the market.
Historical Volatility (HV)
HV, also called statistical volatility. It is a way to measure the fluctuations in the prices of underlying securities over a set period of time. It is less common than implied volatility because it doesn’t look into the future.
When historical volatility increases, the price of a security will also move more than usual. At this time, it is likely that something has changed or will change. On the other hand, if the HV is decreasing, it means that there is no longer any uncertainty, so things go back to how they were.
This measure could be based on changes during the day, but it’s usually based on how the price changed from one day’s end to the next. Depending on how long you want the options trade to last, you can measure HV in increments of anywhere from 10 to 180 trading days.
Takeaways
- Volatility is a statistical measure of how much the price of an asset, security, or market index has increased or decreased over time.
- It is the key factor to look at when pricing options contracts and can be measured by the standard deviation or variance between the returns on the same asset or market index.
- Variance is a measure of the dispersion of returns around the mean of an asset in general, whereas standard deviation is the square root of the variance.
- Beta measures how volatile a stock is compared to the market as a whole, while the VIX measures how volatile the U.S. stock market is expected to be over 30 days.
- Cryptocurrencies have higher volatility than other investments due to their digital nature, lack of regulations, and they are new to the world; hence, take time to adopt and accept.
- Cryptocurrencies are not controlled by any entity, which attracts investors or makes them skeptical.
- Given that cryptocurrency is a digital good, the law of supply and demand determines its price.
- Implied volatility is based on the price of an option and shows volatility expectations.
- Historical volatility measures fluctuations in prices of underlying securities over a set period of time.
