Volatility is a term we’ve all heard before, but few know what it is. On top of that, many wrongly assume that volatility is inherently “bad.” This has caused the term to develop a negative connotation and has resulted in market participants failing to use volatility as a tool to better navigate markets. More often than not, media outlets, reporters, and influencers strategically use the term to induce fear. But little do people know that volatility isn’t necessarily a bad thing and, like all asset classes, is an aspect of crypto that is constantly changing.
In this post, we explain what volatility is, how to calculate & interpret it, and why it’s not necessarily something you ought to fear. After reading, you will better understand why digital assets, like Solana, are volatile and you will feel more confident in your ability to navigate crypto better. That said, let’s dig in!
Volatility, What Is It?!
As defined by Investopedia, “Volatility is a statistical measure of the dispersion of returns for a given security or market index.” Simply put, volatility is how much an asset could in either direction based on its past performance. In traditional financial markets, the more volatile the asset, the greater the risk of the asset losing its value. However, if crypto has proven anything, it’s that assets aren’t only volatile to the downside but to the upside too!
For instance, BTC has been one of the most volatile assets the world has seen over the past decade. However, throughout extreme bouts of volatility, BTC has grown from a few cents to as much as $69,000 in 2021. Similarly, Solana has been several times more volatile than BTC over the past several years, yet has also trended meaningfully higher over the years and continues to exhibit immense potential in disrupting existing industries and creating new ones – such as the world of Decentralized Finance (DeFi), Non-Fungible Tokens (NFTs), and crypto gaming.
How Do I Measure It?
Although there are several different ways to measure volatility, calculating an asset’s annualized volatility is the most common way. Such can be done by taking the standard deviation of an asset’s daily return over a set period (typically 30 days) and then multiplying it by the square root of the number of trading days (252 days in traditional markets, 365 days in crypto). Said differently, we can calculate volatility by looking at how much an asset has moved above or below its average daily return over 30 days (standard deviation). Then we multiply that figure by the square root of 365 to get annualized volatility, or the variation in an asset’s value over a year.
As shown in the figure below, we can get SOL’s annualized volatility by first calculating the daily return of SOL over the past 30 days. We then take those daily returns to calculate the standard deviation (we can use the =STDEV() function in excel), which gets us 4.7%. Because there are 365 trading days in crypto, we then multiply SOL’s standard deviation by √365, which gets us an annualized volatility of roughly 90%.
How Do I Interpret It?
Okay, great. So we know how to calculate annualized volatility, but what does it tell us? While we can use this figure to understand better how much more or less volatile one asset is relative to another, we can also use it to properly set our expectations of the asset’s past and/or future performance.
Because we can calculate the annualized volatility of any asset, we can compare an asset’s historical volatility to others to set our expectations about how one asset may perform relative to others. For example, in the figure below, we can see that both ETH and SOL have historically been more volatile than BTC. Accordingly, it stands to reason that ETH and SOL should outperform BTC in a bull market and underperform BTC in a bear market since prior price swings have been more significant in both directions. However, note that the most volatile assets typically have a smaller market capitalization. Because of their size, The Law of Large Numbers states that it is easier for a smaller asset to outperform a larger asset in a bull market, while smaller assets will take the brunt of the beating when the broader market trends lower.
That’s precisely what we saw in the past 18 months too! Before crypto entered a bear market in December 2021, SOL(+13,150%) outperformed ETH (+525%) and BTC (+135%) between January and November 2021 – hence having a notably higher annualized volatility. However, once crypto markets entered a bear market in November 2021, SOL began massively underperforming BTC and ETH while remaining substantially more volatile.
While we can compare annualized volatility readings relative to other assets, we can use annualized volatility to set our expectations on what kind of moves we should expect an asset to make on any given day. For example, SOL has an annualized volatility of 90% (also known as “90 vol”). We should therefore expect SOL to move ±4.7% on any given day. But why? To get the implied daily move of SOL, we divide its 90% annualized volatility by the square root of 365, or the number of crypto trading days in a year. Knowing SOL to be this volatile, we ought to not be surprised if we wake up one morning to find that SOL is up +5% or -5%. If that’s too much to handle, then one ought to reconsider their involvement in SOL and other cryptoassets with similar levels of volatility.
Though not always the case, volatility tends to come in waves and is a cyclical aspect of markets. Under this assumption, one can look at historical annualized volatility readings to identify trends. Depending on the macro trend, we can guesstimate when an asset might move meaningfully higher or lower given how volatility has trended in the past. We can even use trends to estimate when an asset’s move to the upside or downside is starting to end.
The figure below shows that between 2011 and 2017, the 90-day moving average (90D MA) of BTC’s volatility was forming lower highs and lower lows. This trend created what many technical analysts refer to as a “falling wedge.” Lo and behold, when the 90D MA of BTC’s annualized volatility pierced through the wedge’s downtrending line of resistance, BTC’s gradual climb higher in 2016 was followed by a parabolic rally in 2017. Had one been paying attention to BTC’s macro trend and annualized volatility in 2017, they could have seen that a new era of volatility was on the horizon and positioned themselves accordingly.
Similarly, if we look at the 90D MA of BTC’s annualized volatility between 2011 and August 2022, we’ll see a similar pattern. Per the figure below, since 2011, volatility had been setting lower highs. Meanwhile, volatility was setting higher lowers since 2016. When we draw support and resistance trendlines, we’ll find that BTC’s volatility is currently smack dab between support and resistance. This suggests that either volatility will cool off in the months ahead or continue to climb as it has all year long.
Not only that, but the converging trendlines indicate that, just like in 2017, a new wave of volatility might be on the horizon. Should BTC’s volatility pierce through the downtrending line of resistance dating back to 2011, we could find ourselves in the early innings of perhaps another bull market. But like anything else, history doesn’t have to be repeated, and past performance can only be useful. Accordingly, a prudent market participant should always take past performance with a grain of salt.
While we can look at how volatility has trended in the past for insight into how the asset’s underlying price may trend in the future, we can also turn to the market’s forecast of expected volatility. This metric is called “implied volatility” and is calculated from the options market.
Though implied volatility doesn’t necessarily tell us which direction the market expects an asset to move, we can compare it relative to annualized volatility to get a better sense of how much more or less volatile the market expects an asset to become. As shown in the figure below, we can see that the market is expecting volatility to be notably higher than it currently is. At the time of writing, BTC’s annualized volatility resides at 58%, while the BitVol (Bitcoin Volatility) index has an implied volatility of 79%. Like most other indicators, looking at an asset’s annualized volatility relative to implied volatility can lend insight into whether the market sees a big move coming and in which direction. As of right now, the near 20 percentage point difference between implied volatility and annualized volatility tells us that the market is expecting a notable swing one direction or another in the not so distant future.
Don’t Fear The Volatility!
As with any asset that has risen to prominence over time, its humble beginnings coincided with extreme deviations in price. Though such deviations can deter market participants, said deviations are not necessarily something to fear. Why? Because these deviations merely reflect what inevitably happens when a new technological innovation comes to market. That is to say, waves of financial and human capital drive prices to unprecedented levels in a short period. With these parabolic rises come abrupt and painful drops that persist until sellers are completely exhausted. But because of their potential and appeal, a speculative wave eventually returns and serves as another stepping stone toward even greater adoption. Consider the following technological revolutions that led to market bubbles before being adopted in the masses:
- The Industrial Revolution (1771) led to The Canal Panic (1797)
- The Age of Steam & Railways (1829) led to The Railway Panic (1847)
- The Age of Steel, Electricity, & Engineering (1875) led to The Global Collapses of the 1890s
- The Age of Oil, Automobiles, & Mass Production (1908) led to The Great Crash of 1929
- The Age of Information & Telecom (1971) led to The Internet Bubble of 2000
Ultimately, cryptoassets with true product-market fit and demand, such as BTC, will continue to grow larger over time while their volatility softens. Consider that while BTC, ETH, and SOL are multiples more volatile than traditional assets (stocks, real estate, & bonds), an overarching trend of “down & to the right” has emerged. As shown in the figure below, BTC, ETH, and SOL continue to become increasingly less volatile over the years as adoption persists, and market capitalization expands. So as volatile as these assets might be, it bears mentioning that they all remain on a path toward becoming globally owned digital assets. With said adoption, one can expect volatility to continue grinding lower over the long-term.
That’s A Wrap!
As you can see, there is much more to the term “volatility” than most people think. Not only that, but an asset’s volatility can tell us much more about the past and potentially the future than many believe. It should also be clear at this point that you can use volatility to understand better how an asset stacks up to peers, how it may behave in the future, and why it exists in the first place. Knowing what you know now, it should be a little more obvious why cryptoassets like BTC, ETH, and SOL are as volatile as they are and whether or not their volatility is something you’re willing to stomach. As always, never take on more risk than you’re willing to assume!
|Disclaimer: This information is general information and is intended for educational purposes only. The information contained herein is not intended to constitute legal, tax, accounting or investment advice. Information, opinions and views are solely the author’s own and should not be used as the basis of any investment decision. When making investment decisions, contact a licensed investment professional who can ensure the suitability of your investments. Do your own research.|