What Is Volatility?
Volatility is a measure of the variance in an asset’s price in relation to its average price over time. Assets that fluctuate significantly in price are considered more volatile.
Bitcoin, which has increased in value by approximately 50x in the last five years, is considerably more volatile than most other assets, such as debt or equity. Volatility may indicate the potential for above-average returns on a trade, but it is also one of the main indicators of risk. This can make a Bitcoin investment less predictable in the short-term compared to other investments.
Why Is Bitcoin Volatile?
Many factors have contributed to Bitcoin’s volatility. These factors are primarily related to nascency of the currency and the dynamics of the Bitcoin markets. Investors regularly and drastically change their expectations for the currency based on world events, and the Bitcoin markets are not efficient enough to absorb these supply and demand shocks without large impacts on the market. This can result in drastic changes in Bitcoin’s spot price.
Volatility of a portfolio can be managed through diversification and hedging.
Bitcoin’s Role Is Still Being Established
Bitcoin has only existed since 2009. In that time, it has gone from a small project with a dozen users to a reserve currency used by Fortune 500 companies. The world is still figuring out how Bitcoin will fit into the global economy, and sentiments about the currency are redefined on a regular basis.
As lawmakers and financial institutions continue to address Bitcoin, their actions and statements can cause the supply and demand to have major fluctuations. The price reflects investor’s expectations for the future of Bitcoin, and this future is influenced by actions taken in the present.
Speculation Without Cash Flows
The speculation around Bitcoin is exacerbated by the nature of the asset. Bitcoin’s value as an investment purely depends on the future value of Bitcoin. Alternatively, most assets are priced based on the future value of their cash flows. This might mean the dividends a stock will pay out, or the coupons an investor receives from a bond. There will always be some uncertainty around these cash flows, but they create a relatively clear method for modeling the price of the asset, which creates a perception of lower risk among investors.
Conversely, Bitcoin’s value is not determined by cash flows. Instead, the price and demand depend on how Bitcoin is being used as part of the global economy. This results in a much wider range of price projections, with every assumption drastically impacting price expectations.
➤ Learn more about how Bitcoin's price is determined.
Small Market Capitalization
The distribution of Bitcoin also plays a role in rapid price movements. The mechanics of trading depend on the supply and demand of the asset. Bitcoin gets a lot of public attention, but its market capitalization is only ~$1 trillion, only 10% of gold’s market cap. This makes it possible for a single entity or wealthy individual to single-handedly affect the price by buying or selling bitcoin.
Similarly, large amounts of bitcoin are owned by individual people or groups. If a large holder of bitcoin decides to sell, then the supply of the currency increases significantly in a short time. Assets which have lower market depth will require smaller amounts of capital to have a large impact on the market.
➤ Learn more about how Bitcoin’s market cap compares to other assets.
Immature Markets
The smaller market and recent creation of Bitcoin means that the markets and financial products that support Bitcoin are underdeveloped. Compared to assets like stocks, Bitcoin is very difficult for investors to gain exposure to. The smaller value of the market also yields less market depth for large traders. Additionally, whereas a few major stock exchanges, such as the New York Stock Exchange, dominate the market, Bitcoin liquidity is fractured across many different exchanges.
Most assets will offer a comprehensive set of derivatives and other ways of hedging or leveraging a position. However, Bitcoin derivatives products are only in their infancy, further constraining the ways investor exposure to Bitcoin can be managed. As these derivative products evolve and mature, they will help smooth Bitcoin volatility.
➤ Learn more about bitcoin derivatives market offerings.
Will Bitcoin Remain Volatile?
Many of the factors that drove Bitcoin’s volatility in the past will become less relevant as time goes on. Countries around the world are progressively adding rules to govern how their citizens can use the currency. As the long-term regulations around Bitcoin become more clear, price volatility should decline.
The market moving potential of individual holders is likely to decline as the asset grows. As Bitcoin becomes more expensive, it will require a larger amount of fiat currency to put upward pressure on the market price. Large individual holders will still have the ability to increase sell pressure drastically, putting downward pressure on the price. However, these large holders will not be able to do this forever. Either they will hold their bitcoin and restrict sell pressure, or they will sell their bitcoin, contributing to a more evenly distributed asset.
Finally, the Bitcoin markets are constantly becoming more efficient. Investors are gaining access to new forms of exposure and the markets are increasingly efficient. Efficient markets will allow large trades to occur without outsized impacts on the Bitcoin price. This may not affect the macro trends of Bitcoin’s price, but it will help prevent large swings on any given Bitcoin market.
➤ Learn more about market making.
Key Takeaways
- Volatility is a measure of the risk and potential returns associated with an investment.
- Bitcoin has historically been volatile, due to immature markets and investor speculation.
- Bitcoin is expected to become less volatile as clarity around the currency develops and Bitcoin markets become more efficient.
