Why is Volatility in Cryptocurrency?
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Why is volatility important to understand?
Volatility is one of the primary factors that goes into assessing investment risk. Traditionally, investors will take on a high level of risk if they believe the potential reward is worth the possibility of losing some of their investment. (Or all of their investment, as in the recent case of high-risk hedge-fund manager Bill Hwang, whose entire $20 billion dollar fund disappeared in two days.)
Traditionally, retail investors are advised to diversify their investments within an asset class as a way of reducing risk. One popular strategy is to invest in a basket of stocks (or an index fund), rather than just a few. To further reduce the potential for downside, they may also pair investments in more volatile asset classes like stocks with investments in less volatile classes like bonds.
As an asset class that’s only a little more than a decade old, crypto has seen a series of steep rises and subsequent falls — and is considered to be more volatile as a category than stocks. That said, higher trading volumes on Bitcoin (by far the biggest cryptocurrency by market cap) and increased institutional participation seem to be reducing its volatility over time. Cryptocurrencies with lower trading volumes or emerging cryptoassets like DeFi tokens tend to have higher volatility — when experimenting with these assets as a beginner it’s best to risk amounts you can afford to lose.
Factors that can increase volatility include positive or negative news coverage and earnings reports that are better or worse than expected. Unusually high spikes in volume of trading will usually correspond to volatility. Very low volume (as seen with so-called penny stocks that don’t trade on major markets or smaller cryptocurrencies) also usually corresponds with high volatility.
Are there ways to reduce crypto volatility?
For some crypto investors, high volatility is part of the appeal — it creates the possibility for high returns. (And even as Bitcoin’s volatility seems to be declining, it often moves by double-digit percentages in a single week, allowing for strategies like “buying the dip.”)
For less risk-tolerant investors, there are strategies that can be used to limit the downside impact of volatility, like dollar-cost averaging. (Generally, investors with longer-term strategies who have good reason to believe that an investment will ultimately rise over time don’t need to think as much about short-term volatility.) And there are now cryptocurrencies specifically designed to have low volatility called stablecoins (including USD Coin and Dai) — these have their price pegged to a reserve asset like the U.S. dollar.
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