Cryptocurrency is considered a newer asset class prone to significant price movements over short periods. Regarding price volatility, the general rule is that volatile assets are a riskier investment, offering the possibility of higher returns and the probability of higher losses than other less volatile assets. Let's explore this further!
What is price volatility?
Volatility in a financial market refers to the upward or downward changes in an asset's price. The same can be applied to crypto-assets. Steady increases or decreases in value characterize healthy volatility, while sudden price movements in both directions showcase extreme price volatility. For example, in traditional markets, stocks have a wide range of volatility, from stable to erratic, while investors consider bonds less volatile.
You're probably wondering right now how one can measure such a thing as volatility? We have the answer to that! In order to measure an asset's volatility, you must look at the historical volatility, a number extracted from studying the price over a determined period of time ( between a month and a year).
Implied volatility refers to predicting future price developments, and while it's not an exact science, there are tools that can help with that. Such a financial tool is the CBOE volatility index, also known as the "fear index," which predicts the future volatility of stock markets for 30 days.
If you're interested in measuring an asset's volatility, you can do it in two ways:
- The first method is called Beta, and it implies quantifying how volatile a stock is compared to the broader market ( S&P 500 being the benchmark used).
- The second method involves computing the standard deviation of crypto assets. This can be done by measuring how much the price has diverged from the historical average.
The importance of understanding volatility
When it comes to assessing investment risk, volatility is a crucial factor that must be taken into account. Investors make financial decisions based on what qualifies as a good investment and usually avoid a high level of risk unless the potential reward proves to be worth the risk of losing some of the initial investment. For example, in traditional markets, investors usually diversify the portfolio of assets they trade with, investing in a basket of several stocks instead of just a few. Another strategy is to pair stock investments with bond investments, reducing the risk of losing money.
Crypto is generally regarded as a more volatile asset class than stocks, as it is relatively new and has experienced several dips and rises in a short time. As a rule of thumb, stablecoins are considered less volatile, while other cryptocurrencies with lower trading volumes or emerging decentralized finance tokens have higher volatility. In any case, traders with less experience should limit their investment to amounts they are willing to lose.
Multiple factors can influence crypto volatility, including positive and negative news coverage or how much people believe and invest in the market. Both high and low trading volumes can clearly indicate that a digital currency has high volatility.
How to reduce crypto assets volatility
Crypto's speculative nature is appealing to some experimented investors, as it creates the possibility of high-profit margins. Other investors prefer to stay on the safe side and use strategies like dollar-cost averaging to ease the risks and make the expected profits.
When we're talking about crypto trading, Bitcoin trading, in particular, there's a tendency for investors to follow long-term strategies, not being bothered by short-term volatility. They firmly believe that the asset will rise in value over time, even when it's experiencing a volatile week or year.
As usual, we'll end our article with the best advice- DYOR! In case you don't remember what it means, it's " Do your own research!" Before investing in any digital currency, you should understand the risks and the rewards and always take volatility into account when establishing the total value of your investment.
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