Why is crypto so volatile?
As a crypto investor, you’re probably familiar with volatility — the tendency for crypto to gain or lose significant amounts of value in short periods of time. It may even be the reason you invested in crypto in the first place — after all, that volatility is what can turn small investments into large returns.
But where does this volatility come from? We thought we’d explore a few different reasons for the big ups and downs of cryptocurrency.
Reason 1: liquidity (or lack thereof)
One of the basic aspects of investing is that less liquidity means more volatility. When there are fewer buyers and sellers, at fewer price points, big changes in price become more likely. That’s often the case with crypto, because crypto is not very liquid. There aren’t as many buyers and sellers of crypto as there are for other assets and currencies.
Here’s how this plays out in practice. Say you buy some crypto for $500. Two years later, you want to sell — and you’re willing to sell for any price higher than $600. If there were lots of buyers and sellers at different price points, you’d probably find someone willing to sell for $601 or so, and the price of crypto wouldn’t change very much.
But say there’s only one person looking to buy crypto — and you’re in luck because he’s willing to pay $1,000. You make a quick $400 more than you expected, and the price of crypto shoots up, based on one transaction.
Reason 2: Developing value and use cases
The use cases for crypto are developing, but they’re not as obvious as other assets. This means that price signals aren’t as tethered to a use case as they are for other assets.
For example, you can compare cryptocurrency to oranges. Oranges have a universal, agreed-upon use case: they’re for eating and making juice. There’s really not much else you can do with them. So the price of oranges is set by how much people want to eat oranges and drink orange juice. If the market says that oranges are only worth $3/kg, then the price is not going to rise much higher than that.
But this isn’t the case with cryptocurrency. While cryptocurrencies do have use cases, these use cases aren’t always as obvious, or universal, as other assets. This means that the price is less-connected to the underlying value of the use case, which in turn means that it can move around a lot more — which it does!
This will probably become a smaller factor over time, as more people become familiar with crypto, and start valuing cryptocurrency based on what they can do with it.
Reason 3: Speculation
Low liquidity and unclear use cases create volatility. This creates a third factor: speculation. You probably know this, but speculating is when someone (maybe you!) buys an asset like crypto with the sole intention of selling it for more in the future, rather than using it.
This adds fuel to the reasons we outlined above. When people are buying crypto and holding it for a long time, liquidity is reduced even further. Further, speculating creates more speculation, as more people try to get in on the volatility it creates — this takes crypto’s value even further away from its underlying use cases.
Reason 4: no central bank
There’s no central bank releasing more crypto when demand gets low and buying crypto bank when demand gets high. Rather, crypto price is completely driven by the true supply and demand for that asset.
Without this “smoothing” influence of a central bank, crypto prices can go to whatever people are willing to pay for them — so if demand is volatile, the price will be volatile too. This is not the case with fiat currency, but that’s also (probably) why people don’t tend to invest in fiat currency!
Reason 5: public perception
Finally, all these factors combined mean crypto can be very vulnerable to public perception. A positive or negative media story can move the price significantly in a short period of time. Crypto is more vulnerable to this than other assets because of the four reasons above:
- Low liquidity mean just a few big movements can shift the overall price
- Developing use cases mean many investors don’t need crypto for anything other than investing — so they’re happy to buy or sell off the back of a news story.
- Speculation means that some investors will buy or sell off a price movement that comes from a piece of news, based on how they think it will affect the future price
- There’s no central bank to increase or reduce the supply to smooth out changes brought by the news.
Volatility: good or bad?
All this is not to say that volatility is a bad thing. As we said at the top, volatility can create some big opportunities that aren’t available when buying other assets. But if you’re going to invest in a volatile asset, it’s useful to know where that volatility is coming from. Hopefully, this article helped to shine some light on what drives the big changes in crypto value.
originally posted on Invsta Blog
