So You Want to Trade Crypto  -  Volatility (Part 2)

The Cryptocurrency market is extremely new and has yet to mature with greater regulation and institutional involvement, leading to sharp moves and high volatility as the market grows. This is a double edged sword — heaven for day traders looking for a bit of excitement while adding significant risk to those wishing to trade longer term.

Historical Volatility

Historical Volatility comparison of asset classes.

  • GVZVIX — CBOE Volatility index for Gold
  • VIX — CBOE Volatility index for the S&P 500
  • EUVIX — CBOE Volatility index for Euro/USD pair
  • BTCVIX — Bitcoin 30 day historical volatility (Bitcoin volatility on right axis as it’s so much higher)
Volatility_comparison.png

As we can see, there is a clear correlation between the volatility of more traditional traded assets, especially so during events such as the 2009 bounce. Bitcoin, on the other hand, seems to hold limited correlation to any of these other classes of products, even when factoring out the huge difference in average volatility.

Even the volatility of equities, currently at 13.4% from the VIX, is completely dwarfed by that of Bitcoin, coming in at 70% (down from 150% earlier in the year) — and Bitcoin is historically one of the less volatile Cryptocurrencies. Cryptocurrency markets represent a huge shift in gear, incurring more risk while giving the possibility of greater reward.

How to manage the volatility

Managing downside risk is an important part of any successful trading strategy, more so in the extreme volatility of Cryptocurrency. I personally prefer to define a hard stop-loss level prior to each trade, however a “soft” soft-loss/ exit parameter can be sufficient depending on the frequency of the trading strategy.

Very few Crypto exchanges cater to higher frequency trading at the moment, making faster trading strategies more difficult if not impossible in many cases. High frequency market making or scalping strategies are less concerned with hard stop-losses, due to the extremely short exposure to directional risk.

As hold duration for each trade moves into the span of minutes, absolute risk is still relatively limited in most cases. However, as in any market, there are occasional spikes in volatility — but these can be amplified too.

 12th Apr 2018 — A move of $1200 — greater than the entire span of previous 2 weeks

12th Apr 2018 — A move of $1200 — greater than the entire span of previous 2 weeks

The risk:reward ratio of each trade is an important factor to a profitable trading system, along with the success rate 

If there is no plan for risk management, a black-swan event (such as the margin cascade seen above) could undo a week’s profits — or even wipe out a while account.

Moving into longer term strategies, such as swing trading

Volatility makes common strategies trickier. The simplest way to reduce the risk on a trade is to reduce position sizing on signals with lower confidence. For example, in forex trading, leverage is widely used to make efficient use of capital on relatively smaller movements. Meanwhile, it’d be madness to take that level of leverage on a Crypto swing trade. Risk doesn’t have to be any higher between asset classes, as long as volatility is adjusted for.

From active trading strategies into indexing, the Cryptocurrency market has provided huge returns over the past couple of years, with the total market capitalization rising from $18.3B at the start of 2017 to $613B by the start of 2018 — over 3000% growth. Unfortunately, past performance isn’t indicative of future returns — it would be impossible to continue at such a rate. Between Jan 2018 and Apr 2018, there was a pullback of 60% from which we’re still recovering.

An automatically re-balanced Cryptocurrency index fund can offer a simple but effective way to gain diversified exposure to the market, but be warned that you will have to be able to stomach the possibility of high drawdowns.

Volatility and Speculative Assets

As I mentioned in the first post of the series, Cryptocurrency cannot be analyzed in the same manner as traditional assets. You have no physical item or stake in a company to which the price is tied. The whole valuation of your token is based on the expectation of future demand, and is thus very susceptible to changes in sentiment.

A stock will be priced above the value of its dividends and assets to account for the expected growth in the business over time. However, during a market downturn, investors become less optimistic about the future as the economy constricts, driving down prices. The business itself may lose some revenue as consumers of the economy have less cash to spend, but there is still a functioning business with value.

Meanwhile, the whole success of Cryptocurrency relies on the ability of a project to attract businesses and developers to use the platform. Speculators are betting that the project will be successful in this goal long term, but there is no tangible asset to retain value if the project falters or market sentiment shifts against it.

This is one of the main reasons why the Cryptocurrency market remains so volatile compared to any other asset class

While this effect will reduce over time, as successful applications and businesses form in the ecosystem, it will not be a quick or easy process.

by Matthew Tweed

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