You’ve gotten involved in cryptocurrencies. You know that, in general, volatility in this type of asset tends to be higher than most. Now you’re realizing that the trend of increased volatility during the COVID pandemic is even more marked in the cryptocurrency space.
Recent reports on Bitcoin prices measured for 30-day volatility peaked at 200% in April 2020, and with an average level of volatility of 68% over the prior year. For comparison, the S&P 500 had, during the course of the past year, average volatility in the low to mid-teens.
During the time it took to put together this piece, for example, the price of Bitcoin reached a high of just under $12,000 to a low of just above $10,000, a nearly 17% drop in a week. If you had shorted during this time, it would have been a tidy payday.
This level of volatility is not necessarily a bad thing. Any experienced investor will tell you that volatility is another aspect of the world of assets, and you can manage it through proper investment strategies and handling.
This high level of volatility means prices will change drastically, allowing you to make a significant profit if you’re able to navigate it. Handling the associated risks is key to investing in any asset, and at the end of the day, cryptocurrencies are just an especially volatile and technically complicated asset.
Pro tip: Are you planning to start investing in cryptocurrencies? Coinbase is one of the largest platforms to buy and sell Bitcoin and other altcoins.
The Fundamentals of Managing Cryptocurrency Volatility
There are a series of fundamentals for dealing with volatility across any investing vehicle. Avoiding overconfidence or underconfidence can be key. So are the following strategies.
1. Avoid Emotionality
Scroll through an online chat room about investing in cryptocurrencies, and you’re bound to be bombarded with people trying to sell you on the emotionality of a particular investment.
Seeking to induce fear of missing out (FOMO) is a common strategy. A large number of offerings imply that a particular coin is the next Bitcoin, ensuring that tens of thousands of dollars can come your way for the mere cost of a few dollars.
Emotionality is rampant in the cryptocurrency space, and you should avoid it. Many journalists and observers have been caught by the shiny bauble that the relatively small cadre of overnight millionaires from Bitcoin represents.
The high school student who suddenly ended up with millions had no way of knowing Bitcoin would reach the prices it did, and many investors are subject to survivorship bias, believing they made their money because of their skill and ignoring the others who lost on similar investments.
The cases of Bitcoin millionaires were an aberration from the norm, and no one involved in the first generation of Bitcoin investors knew that it was going to happen. The survivorship bias is strong among those who profited from that period, and many livelihoods have been created based upon selling that dream to the unwary.
This is a perfect example of the kind of emotionally led thinking that can lead to poor decision-making, chasing the best-case scenario at the expense of paying attention to the indicators behind an investment.
2. Don’t Try to Time the Market
The volatility of cryptocurrencies means that, by and large, finding or planning a time in advance to buy in is a difficult, if not impossible, proposition.
Getting into the market at a good point in time can be effective, but it’s undeniably harder to time cryptocurrencies than typical assets. Approaching with a flexible but unemotional tact is your best bet.
Within a short time period, timing the market will be nearly impossible. Bitcoin is like nearly every other asset in the sense that although the fundamentals can be understood, the changing beliefs surrounding them can prop up or depress prices.
Having your finances prepared to act on sudden drops on the market and being prepared to hold for longer periods of time will be key to handling cryptocurrency volatility.
3. Know When to Hold
It has become a meme for those in online cryptocurrency groups to say that people should Hold On for Dear Life (HODL) until they’re able to have the return on investment they’re after. People talk a great deal about timing the market, and much ink has been spilled on this particular issue.
When it comes to cryptocurrencies, the high levels of volatility are neither a bug nor a feature. They’re just part of the environment.
Any time a cryptocurrency is going through a particularly wide swing, holding on and remaining calm is going to save you money. Because of cryptocurrency’s volatility, when market corrections happen, they can be sudden and drastic.
Historically, there have been several major dips across many cryptocurrencies, and several bubbles that are driven by big movers in the market, causing prices to move drastically.
These can come and go faster than in the stock market, with institutions and transaction fees for the retail investor helping to create some ballast to help soften the swings of the market.
A relatively small set of sell-offs or larger buy volumes can result in vast swings in the price of cryptocurrencies because of the spreads of buy and sell orders — the difference between the price buyers are willing to pay and what sellers are willing to accept.
There is a lack of protective buy walls, which would help to limit volatility, in many cryptocurrency markets. Buy walls are a factor of mature markets where a number of (usually institutional) investors set up a series of buy orders for options or underlying assets to capitalize on a large, sudden shift in value.
In essence, if the price were to start to plummet due to a large sell-off, these buy orders would be filled and help to mitigate the change in price.
Jumps in price are part of investing in any cryptocurrency, and knowing when to hold your purchase and trust your analysis rather than overreacting to a sudden change in price is integral to your success.
There are a lot of voices in the cryptocurrency space, and it’s worth taking their opinions with a grain of skepticism.
It’s harder to diversify within the cryptocurrency space. Approaching it like an economist, we can treat it as though there are aspects of all cryptocurrencies that are going to, broadly, trend together.
Good news for cryptocurrencies as a whole often affects most cryptocurrencies in similar ways. For example, when Goldman Sachs abandoned their interest in a cryptocurrency trading desk, several currencies plummeted.
Diversification here means you should not put all your investments in the cryptocurrency space unless you’re more interested in gambling than investing.
As a result, the best approach for diversification should be to put only a subset of your larger investments into cryptocurrencies. Your risk tolerance will ultimately help to make this determination, but cryptocurrencies should be treated more like volatile stocks to be entered into on a longer timeline.
5. Hedge Against Risk
Several exchanges have already released a number of options for helping to address and handle the volatility of cryptocurrencies.
Although there are myriad financial instruments designed to deal with cryptocurrency volatility, they ultimately fall back upon the same fundamentals of using options as every other asset — namely that cryptocurrency options can be used to either hedge against or try to profit from higher levels of volatility.
Given the particular set of circumstances surrounding cryptocurrencies, exploring options may be an effective strategy because immature markets are more prone to mispricing options. Covered calls in particular can be an effective strategy to cover the risk inherent in holding an asset like investments.
Securing effective options for your cryptocurrencies can be a relatively effective hedge for these assets.
Assuming cryptocurrencies are a part of your larger investment strategy, it can make sense to hedge your exposure within the cryptocurrency space through a couple of separate coins, ideally ones without too high of a correlation in their moves.
Bitcoin and Ethereum have often been compared to gold and silver in the way their price movements correlate to one another.
Some cryptocurrency markets have already developed and sell futures on the cryptocurrencies they trade. These futures allow you to make more complex bets based upon future values of your cryptocurrency of choice.
Handling these through covered bets ensures that you’re able to protect yourself, in part, from extreme alterations in prices over the lifetime of your investment.It is worth noting that most of these markets are often altered by a relatively small number of traders and can be subject to higher levels of volatility.
Contracts for Difference (CFDs)
More complex financial instruments have already been created as derivatives to larger cryptocurrency markets, though often only for relatively robust coins. Contracts for Difference, or CFDs, are an agreement for a buyer and seller to pay the other for a change in the value of the underlying asset.
In essence, the closing price of the asset is subtracted from the initial price: if the result is positive, the buyer pays the seller the difference; if it’s negative, the seller pays the buyer that difference.
CFDs are investments created to make a relatively straightforward bet about the direction in which the related investment is going to go. They exist across a number of different investments besides cryptocurrencies.
They’re often used to allow investors with a relatively smaller position to be able to leverage themselves into betting on a much larger scale. In turn, this allows investors to hedge their position with a relatively small capital outlay.
Some investors do the entirety of their bets based on the approach of buying and selling CFDs rather than trading directly through the cryptocurrency in question.
This can put you into a tricky position where you’re trading the entirety of your exposure without even the underlying asset of a particular cryptocurrency to offset or handle that difference.
Using cryptocurrency CFDs allows you take advantage of the aforementioned volatility without having to position yourself with the same exposure.
While this can often be closer to gambling than investing, CFDs can be used with other pieces of your approach to hedge against larger risks. Covered CFDs in particular can help to offset this high level of risk.
Understanding What You’re Investing In
As with any other investment vehicle, it’s important to understand cryptocurrencies as an asset when you’re investing in them. But with cryptocurrencies, you may have more parties trying to convince you of something contrary to reality.
Most cryptocurrencies lack any inherent value, despite assertions to the contrary by gurus or self-proclaimed experts. Many of the coins that have done particularly well have succeeded either due to their perceived value or because there is something intrinsically different in how they’re set up.
The joke coin DogeCoin (DOGE) is a great example of this. Over the past year, the value of a single DOGE has not reached one cent, although it still has a great deal of volatility in this sub-one-cent range. DOGE is relatively tricky to convert into other currencies and, frankly, it’s probably a poor investment in anything besides humor.
A more moderately risky option is something like Akoin, a cryptocurrency that is functionally backed by rapper and entrepreneur Akon. Claiming inspiration in part from the fictional country of Wakanda, the cryptocurrency is a keystone in the development of Akon City in Senegal, a cryptocurrency-run city.
Depending on how development of the city bears out, this may be more reminiscent of modern currencies being backed, in essence, by the value of the government behind it.
Thus, avoiding lesser-known cryptocurrencies or ones that are not as well covered helps to minimize the volatility you’re exposing yourself to, and to ensure there isn’t a scam taking place.
Unfortunately, this remains a concern in the cryptocurrency space because there is still an active group of individuals who seek to capitalize on the misunderstanding of what cryptocurrency technologies are and what they can do.
In general, you shouldn’t trust the overly hard sales pitches for any particular coin. Instead, trust your own judgment of the fundamentals of each coin you’re considering investing in.
Some currencies, like the Stronghold USD or Petro cryptocurrency — collectively called stablecoins — are pegged to some relatively real asset. The values are tied either to a government-backed currency or to a precious metal.
These currencies are relatively less common and have not proven to be particularly interesting investment vehicles. Because they’re tied to set value and they lack the capacity to float differently and remain relatively illiquid, it often is a better decision to invest in the primary asset instead of the pegged currency.
The Challenge of Exchanges
Cryptocurrencies lack the major centralized exchanges stocks and bonds have. Instead, the entire market capitalizations for most coins are spread across a multitude of exchanges, each with slightly different processes, rates, and procedures.
The problem is such that there is a small cottage industry that runs automated bots that seek out and execute on arbitrage opportunities between different exchanges. Ultimately, these only tend to make beer and pizza money, but the fact that they exist represents an immaturity in the larger industry.
The result is that not only is it easier for a small number of trades to drastically change the price point on a single exchange, but it’s also substantially harder to enact any sort of price protection like those discussed above.
It is possible to try to play the game of maneuvering across multiple exchanges, but there are the previously mentioned instances of automated systems snatching up arbitrage opportunities. Trying to play that game is more likely to result in a lot of extra effort being expended without resulting in any particular advantages.
With the market for cryptocurrencies maturing, it’s important to keep good records and ensure that your investing in cryptocurrencies is included in your accounting.
Many jurisdictions count gains from cryptocurrencies as capital gains and tax them accordingly. The entire asset class is going through regular updates to how it is taxed and covered, and robust records will be a boon when tax time comes.
Though the market is far from mature, it is no longer the Wild West it was a few years ago. Many governments are doing everything they can to ensure they’re able to tax cryptocurrencies, with regulations and laws often being nearly as volatile as cryptocurrencies.
The ultimate takeaway is that cryptocurrencies are an investment vehicle that requires an increased level of technical acumen and likely some additional attention, but by and large, they follow the same rules as any standard investment. With increased volatility across numerous investment classes, it can be difficult to handle the emotionality of this type of investment.
Sticking to a strong level of fundamentals, combined with educating yourself about the particularities of these newer markets, is the best bet to invest in cryptocurrencies. They are going to be highly volatile, but proper preparation and approach allow you to maximize that to your advantage.