What exactly is volatility?

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Explanation

Volatility is an indicator of how much an asset’s price has risen or fallen over time. In general, the more volatile an asset is, the riskier it is as an investment — and the greater opportunity it has to deliver either higher returns or higher losses over shorter time spans than relatively less volatile assets.

Volatility is an indicator of how much the price of a certain commodity has risen or fallen over time. In general, the more volatile an asset is, the riskier it is as an investment — and the greater opportunity it has to deliver either higher returns or higher losses over shorter time spans than relatively less volatile assets.

Crypto, as a younger asset class, is generally regarded as unpredictable, with the potential for major up and down swings over shorter time spans. Options are thought to have a wide variety of fluctuations, ranging from the relative stability of large-cap stocks (such as Apple or Berkshire Hathaway) to the often volatile “penny stocks.” Bonds, on the other hand, are considered a lower-volatility asset, with fewer dramatic upward and downside movements over longer time periods.

How is volatility measured?

When people speak about calculating volatility, they usually mean “historical volatility,” which is a statistic calculated from a market analysis over a given time period (often 30 days or a year). The estimation of future fluctuations is known as “implied volatility,” and since no one can foresee the future, it is a less exact science (though it is the basis for commonly used financial instruments such as the Cboe Volatility Index, dubbed the “fear index,” which forecasts stock market volatility for the next 30 days). There are two methods for quantifying volatility:

  • You can use a method called beta, which measures how volatile one stock is relative to the broader market (the typical benchmark is the S&P 500).

  •  You can compute an asset’s standard deviation, which is a measure of how widely its price has diverged from its historical average.

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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.

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Are there ways to reduce crypto volatility?

High uncertainty is appealing to some crypto investors because it offers the likelihood of high returns. (And, while Bitcoin’s volatility seems to be decreasing, it still swings by double digit percentages in a single week, allowing for tactics such as “buying the dip.”)

There are techniques, such as dollar-cost averaging, that can be used by less risk-averse investors to minimise the downside effect of uncertainty. (In general, investors with longer-term plans that have strong reason to assume that an investment will eventually increase in value do not need to consider short-term fluctuations as much.) Stablecoins (such as USD Coin and Dai) are cryptocurrencies that have their price fixed to a reserve currency such as the US dollar and are deliberately built to have low volatility.

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