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27 Nov, 2018, 12:06 PM 9 Print out
Hugo Van Veen

Co-Founder & Chief Investment Officer

Volatility can hamper any investor’s enthusiasm, regardless of positive long-term growth projections. Emotion ultimately seeps into the investment process, with fear and greed at the forefront. Volatility plays upon an investor’s fear, and traditional investors curious about crypto often avoid the asset class due to volatility alone.

Recent years demonstrated that Bitcoin’s individual volatility affects the broader crypto market’s movements. Due to this relationship, an analysis of Bitcoin’s fluctuations can help investors understand the overarching crypto market’s price behaviour.

The rate at which a price of a security increases or decreases is defined as volatility. In more technical terms volatility is the standard deviation of the daily price change. Bitcoin’s historical annualised volatility has been between 60–120% compared to the single stock volatility of large market cap equities of 15–30%.

“Implied volatility” is the forward-looking expected volatility used to price options. Implied volatility is an accurate proxy of how the market predicts the actual volatility looking forward for the underlying asset. The implied volatility analysis yields similar conclusions where Bitcoin volatility is expected to be approximately 4x that of equity market’s volatility.

Crypto volatility = approximately 4x Equity volatility

Bitcoin’s volatility can be attributed to many factors. When the fundamental value of an asset is difficult to determine, and there is no well understood collective opinion of intrinsic value, the determinants of price become highly dependent on the supply and demand dynamic. It is therefore revealing to examine the relative demand vs supply metrics and to compare that to the metrics of other asset classes. In investment parlance this is called the “turnover ratio”, a commonly used ratio that compares sellers versus buyers of a particular asset.

Turnover ratio is calculated by dividing the daily volume of an asset by the “float” of an asset, which is the value of the shares/units available for sale by the general trading public. Ideally the illiquid and non-traded portion of assets need to be excluded from the supply dimension, but this is difficult to determine in most cases. Daily turnover ratio is effectively the percentage of the market cap traded intraday.

Daily Turnover Ratio = Daily volume by value / Market cap

A low turnover ratio suggests that a sudden rush of buying will not affect the value of the asset due to substantial availability. However, a high turnover ratio indicates that relatively few shares/units are available, and a sudden increase in demand could have a considerable effect on the value.

When Bitcoin turnover ratio is compared to the largest individual shares traded in the US, it demonstrates that Bitcoin’s turnover ratio ranks as quite normal. Bitcoin therefore trades at the same volume relative to the market cap of most larger US equity shares.


However, if one studies the price action relative to turnover ratio, then it is evident that Bitcoin exhibits abnormal price action behaviour. When Bitcoin experiences an increase in relative trading volume (i.e turnover ratio), then the price swings are far greater than that of the equity counterparts.

This sensitive price action can likely be attributed to Bitcoin’s very large illiquid pool of assets. A relatively small number of large Bitcoin wallets contain the majority of stored BTC, and these wallets seem to operate under buy and hold strategies. There are 22.3 million Bitcoin wallet addresses with only 4,000 addresses accounting for 50% of all Bitcoin stored. Many of the exceptionally large addresses are crypto exchange cold wallets, and these trade actively each day, but most of these addresses never experience an outflow.



The above statistic reveals that if one excludes the top 500 largest wallets, then 95% of wallets are not traded. This indicates that Bitcoin is very thinly traded across non-exchange addresses. 15.8 million of the 17.3 million Bitcoins remain in dormant addresses, representing 91% of all Bitcoin by value.

91% of Bitcoin value is held in dormant wallets

It may be argued that Bitcoin is not directly comparable to a publically traded share, but the analysis is so far skewed that the merits of the comparison are still valid. Bitcoin also has many of the attributes of a traded share in that the majority of BTC represents a speculative investment and not a medium of exchange. This is evidenced by the high number and percentage of dormant wallets.

In fact, most crypto assets experience a high percentage of dormant wallets. So similar conclusions can be drawn regarding the broader crypto market as there seems to be very low liquidity across the board.

In conclusion, Bitcoin experiences higher volatility, and also higher price fluctuation to relative volume trade when compared to equity counterparts. The large number or dormant wallets leads to low liquidity which explains the high volatility. The majority of cryptos experience a large percentage of assets locked away in stagnant wallets.

The high Bitcoin volatility will also have a contagion effect on the broader crypto market. Until the supply and demand dynamics change, or there is a universally accepted intrinsic value range for crypto assets, it is difficult to recognize why the crypto market will become significantly less volatile in the short to medium term.

The introduction of hedging instruments such as futures and options should stabilise the volatility to some extent, but it seems most likely that volatility will be an ongoing phenomenon.

Crypto market volatility will in all probability be a feature of the asset class in the medium term

Any allocation methodology should view investments holistically. With crypto, volatility represents a substantial hurdle for risk management. However, as part of a diversified portfolio, crypto’s fast-paced movement can be a boon. The commentary on the asset class too often neglects crypto’s favourable uncorrelated characteristics. Crypto investing should be considered over a long-term investment horizon and viewed as a means of diversification. The short-term volatility should be managed by appropriately sizing the investment quantum to make price swings, up or down, cushioned in the overall portfolio, as opposed to viewing volatility in isolation.

References

https://bitinfocharts.com

https://data.bitcoinity.org

https://www.deribit.com

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