Volatility is a tool that allows an investor not to lose their money in the cryptocurrency or other financial instruments market. In this article, we discuss what it demonstrates and how you can use it.
Volatility meaning explained
What does volatility mean? The definition of volatility is simple: it is an indicator that reflects the change in the price of an asset or commodity over a certain (usually short) period of time. Sometimes, volatility can be referred to as stock, market, or trading — there is no difference between these definitions.
For example, yesterday a share of a company was worth $500, today its price rose to $700 at the open of the market, and at the close it was already sold for $400. This is a high volatility of the share price, as the price changes quickly (within one trading day). If the price doesn’t change much (today, stocks are worth $100, tomorrow it’s $100,001), investors talk about low volatility.
The higher the trading volatility, the greater the risk for the investor. However, if you can predict the direction of volatility using its current and historical values, then you can make a lot of money from it. The index is calculated based on forecasts and not on actual data from trading strategies. Yet, even in the forecasts, the laws of mathematics work, which we will discuss later in this article.
Implied volatility is the volatility most commonly used by investors when calculating the benefit of purchasing options. Options (including implied volatility options) are securities, financial instruments, if you like, investments that allow you to purchase various assets from Bitcoin to grain or currency, for a predetermined (at the time of buying the option) value.
The date of the asset’s purchase (in our example, Bitcoin, or grain) is also set at the time the option is purchased. The option does not force the buyer to purchase the asset. It only provides an opportunity to do so, insuring the client against a serious increase in the value of the asset and other factors.
Implied volatility is the volatility in the price of the underlying asset (again, Bitcoin or grain) that corresponds to the market price of the option minus its intrinsic value. It is not about the real price of the underlying asset.
Relative volatility, whose index is called RVI, shows the standard deviation of prices in a certain time period. The RVI is usually presented as a graph or chart ranging from 0 to 100.
Sometimes this index can be stated in a percentage. It all depends on the calculators you use to determine it. If the relative volatility index exceeds 50, then the volatility is growing, and you can buy the asset. If it does not exceed this number, the volatility “stays in place”, that is, it does not exist, or it is decreasing, which means that you can sell the asset.
Stock market volatility
In the stock market, volatility means not only the deviation of an asset’s price from its average values in a certain period, but also the deviation of the return on the said asset. As is the case with cryptocurrencies, investors in the stock market are not immune to volatility, which does not prevent them from making money on it.
In the stock market, novice investors are much more likely to sell volatile assets in a panic than in the cryptocurrency market. This is because crypto investors are already expecting volatility, while “ordinary” investors are not always ready for it. In the stock market, they are used to referring to annualized volatility, while crypto projects care more for daily volatility.
Due to asset volatility, stock market investors try to diversify their portfolios. In other words, they buy various stocks, bonds, shares of funds so that price fluctuations do not “eat up” all their savings. Thanks to this, they make money on securities, and don’t monitor the volatility of one purchased asset every day.
In the stock market, high volatility is considered a price change of 1-5% per trading day. The most stable in terms of volatility are bonds, while the most risky ones are derivatives, that is, financial derivatives like options (which we discussed before).
The cryptocurrency market is always volatile. Peak indicators of asset price changes can reach tens of percent, which is impossible to imagine happening in the stock market. What are the reasons for the crypto volatility phenomenon? We identify several of them.
- Cryptocurrency has no state regulation. Some countries are trying to create laws on the circulation of cryptocurrencies, others – like El Salvador – make blockchain coins the main means of payment, and some countries even ban them. Basically, there is no consensus, as well as the regulator. And that’s a good thing!
- Crypto is not tied to tangible value. Almost all cryptocurrencies (except for stablecoins and some projects based on the real economy) do not depend on the exchange rate of fiat currencies, oil and gas supplies, and official reserve assets.
- Cryptocurrencies have no real value, such as the capitalisation of a company offering its shares on the stock exchange.
- Cryptocurrencies attract numerous newbies, who make even more mistakes by selling and buying assets without an accurate analysis of the market state.
What is volatility index
The Volatility Index, also called the VIX or the Fear Index, shows the level of change that investors expect in the price of an asset. It is based on investors’ assumptions about price volatility and is considered an indicator that measures market sentiment. Why is it called the fear index? Well, it signals the rising panic among investors better than any other tool.
A properly calculated indicator is a tool that helps an investor evaluate the change in asset prices over a given period of time and notice a particularly strong volatility skew.
Volatility indicators help to find the points at which the growth or fall of the price stopped, and the trend changed. Using the data, they can predict the behaviour of the asset price in the future. We need this tool to make money, because it allows us to determine whether to buy a certain asset now or wait. Volatility indicators will come in handy for you at a higher level of managing crypto trading tools. Nevertheless, we will list the main ones. Professionals often require knowing ATR (the average true price range), BB (the so-called Bollinger bands) and KC (standing for “Keltner channel”).
In addition, the volatility contraction pattern may come in handy. It is a decrease in volatility that helps you manage money wisely within one trading day.
How do you calculate volatility? Let’s use a formula suitable for most financial markets, including the crypto one. Notice: in the Forex market, this formula will be several times more complicated. Therefore, if you are going to earn money not within cryptocurrencies (or not within the framework of the “standard” crypto market, but with intersections with the Forex market), study the formula for Forex traders.
σR = σ√R
R — number of periods (candlesticks you are monitoring) in time
σ — standard, historical deviation (historical volatility)
σR — volatility over time (same timeframe as in the case of R)
How to calculate volatility using logarithms: an advanced method
Let’s imagine that you and I are buying options with cryptocurrencies. We need to see whether our purchase will be profitable. To do this, we will calculate the daily interest yields on the asset (in this case, the option). We use the logarithm of the price ratio.
Our option is worth $100. The next day, its price rises to $102. Divide 102 by 100, subtract 1, and multiply the result by 100 percent. We get 2 percent. Now let’s imagine that the price of the option drops to $100 the next day. The fall will amount to -1.96 percent; we crunch numbers using the same formula as before.
This was a beginner-friendly example. However, to exclude possible errors caused by this calculation method, we recommend using natural logarithms.
Volatility is always related to the economic side of the issue. Fiat money is the clearest example of volatility. Think of the Turkish lira or rouble, whose exchange rate against the dollar has fluctuated a lot lately. While the rouble “grew” and its volatility stopped scaring investors, then the lira, on the contrary, dropped.
As we’ve already said in this article, almost all financial instruments are volatile, whether it be shares of oil companies or cryptocurrency. Just remember the constant change in the price of Bitcoin, which at first could buy you a slice of pizza, and a part of the metropolis a few years later. Other crypto coins are not far behind: at one point, the Ethereum exchange rate bounced around from $1,400 to $140.