Understanding the Math Behind Crypto’s Violent Ebb and Flow
For anyone who has invested or traded in crypto, they are well aware of just how volatile the value of cryptoassets can be. The volatility is largely due to cryptocurrency simply being such a young asset class, but there are other factors that I will cover in this piece. Every coin has its share of drastic movement as crypto slowly crawls in the direction of mass adoption, and markets slowly attain thicker order books. But not all coins are created equal, and this sentiment is very much evidenced in the differences in how they are traded and how their values fluctuate in these early years.
Large cap coins like Bitcoin and Ethereum are comparatively stable in price compared to some of the newer tokens out there with less liquid markets — like 0x, OmiseGo, Dash, or NEO. But in crypto, there are no real tokens that will shield you from major with the obligatorily mentioned exception of dollar-pegged stablecoins such as US Tether (USDT) or True USD (TUSD). There are several reasons why the markets are this way:
- Order Books are Thin — One large market order can drastically shift the value of a coin, due to the high amount of coins being traded in proportion to the overall small size of an entire exchange’s order book for that coin. The ability to shift values with one order also happens to be a large factor in why manipulation, which I’ve written about previously, is so prevalent in crypto.
- Lack of Intrinsic Value — As investors in a new space with very few fundamental resources to dictate a particular coin’s value, there really is no consistent way of intrinsically valuing a cryptoasset. Yes, we can research innovation in how tokens are utilizing blockchain technology in more advanced ways than their peers. But for the most part, we simply rely upon future use cases and sentiment toward eventual real world adoption.
- Lack of Regulation — Cryptocurrency does not have any centralized overseers ensuring responsible trading and reasonable market fluctuations. Values are essentially created by what markets and sentiment make of it, and there is no FDIC backing to ensure crypto is traded within a reasonable pattern or range.
In addition to the above reasons, we also see other factors that usually don’t apply to traditional stocks, such as the lack of institutional investors. Institutional investors are often needed in illiquid markets to create stability to prices of assets and commodities. They provide the heavy volume that is necessary to create substantially stable and high volume markets. According to Guillaume Belisle at The Blockchain Journal,
“A lot of high net-worth hedge funds or venture capital companies invest in the cryptocurrency market and are paying attention closely to what’s happening in the market. However, most of the big institutional investments are not made in the cryptocurrency market. Many financial institutions believe that the blockchain technology has potential on the long-run, but have not committed important sums of money to the market.”
The volatility of a particular coin (the magnitude of the deltas between its highs and lows, within a specific time frame) is actually relatively simple to measure. Just like we can use a stock’s beta to measure its particular level of movement vs. the overall stock market, we can measure any coin’s volatility on a percentage basis over any timeframe we so choose. By finding the high and low of any coin’s price within that period, then comparing it to the mean (average price), you can measure the difference of each extreme compared to that mean. Nope, not done yet. Then, you square those numbers (I promise this is easier than you likely think) and divide by the amount of total values you have in your dataset. To some, this may seem somewhere between “slightly daunting to calculate” to “there’s no way in hell…” But don’t fear! There are freely available resources on sites like Level, which actually utilize standard deviation and volatility percentages of daily return.
No, this isn’t a crypto trader. If it was, his mouth would be even wider. Many who have been in the space have felt a similar anguish. The massive swings that occur in crypto can undoubtedly be too much for many to bear. Photo courtesy of: https://www.businessinsider.com/cme-to-close-open-outcry-futures-trading-2015-2?r=UK&IR=T
Now, a lot of people can mistakenly relate a coin’s overall strength as an investment simply by looking at how little the value of it wavers. If this were the case in traditional investing, then minimally moving assets like bonds would be every experts’ investment vehicle of choice. Many stray away from investing in cryptocurrency entirely after discovering that prices can potentially shift 10%, 20%, or even 30%+ in a given day. Although there have been historic days where significant swings have occurred in crypto’s highest market cap coin, Bitcoin, the presumption that jumps and dips like this happen on a daily basis is false and greatly exaggerated.
Regardless, the swings that do occur are not for the faint of heart. The conservative, experienced traders out there who seek 4–8% gains per year from their old reliable stocks, bonds, and equities, ask why anyone would put themselves through this. The wild fluctuations that cryptocurrency requires its traders to tolerate seems completely nonsensical to the trader out there who is looking to safely make a small guaranteed profit on their investments year after year. But there are rewards for those who can stomach the swings of the cryptoasset roller coaster, and some of those rewards have been historically quite handsome. Particularly in the long run.
Embracing Risk & Reward Through Breaking Down the Sharpe Ratio
We have to remember that coin values can move up just as quickly as they can fall down. Investors who fear a coin investment loss of 20% in one month forget that there alternatively may be a 40% gain on the horizon in that same timeframe, which we have seen occur on multiple occasions in 2017 alone. With cryptocurrency still in its infancy stage, order books are thin and portfolios are consistently rollercoastering. If we are really looking to control our potential returns and losses to align with our risk tolerance, we need a metric like the Sharpe Ratio to help lead us down the right path.
Think of prices like yo-yos that move up and down as a particular market attempts to dictate how valuable the asset is. Some of these coins have yo-yo strings significantly longer or shorter than others, and more stable coins simply can not reach as far upwards or downwards due to their shorter strings (lower volatility). These string lengths of various tokens depend on the market cap of the coin, as well as the size of their order books. This unsophisticated comparison demonstrates a coin’s historic and predictive range to move up or down in price over a given time.
If only trading were as simple as dual-wielding children’s toys…
Also, keep in mind that just about every coin moves in fairly tight correlation to the value of Bitcoin... Just in a more volatile version of that direction. This is largely due to the trading pairs offered on most exchanges being mostly associated with Bitcoin. At some point, this may change. But for now, as investors, this is just something we need to accept when doing our research. Andrew Munro discusses diversification, correlation and mathematical ratios like Sharpe in his eloquently written article:
“In general, the risk reductions associated with diversification are dependent on the number of different asset types in a portfolio, and how closely correlated each of them is.”
I have written about diversification being a thing in crypto, and a very good thing to take advantage of on sites like Level. However, there are limitations to how much one can really diversify when most coins are moving relatively in the same direction. Diversifying in crypto largely correlates with having a well spread mix of large cap, mid cap, and small cap coins, then spreading them out based on your risk tolerance and, of course, your belief in their future adoption.
Since Bitcoin has the largest market cap in the crypto world, currently sitting at $109.3B, the volatility percentage has been and will consistently be the lowest or one of the lowest of any tokens you can trade. This is a good thing, particularly for the more risk averse traders out there. However, plenty of coins, despite higher volatilities than Bitcoin, have outgained it by wide margins over short-term and long-term durations. Don’t forget that volatility measures movement in either direction.
This is why we, as investors, would ideally like to factor in overall return into the amount of risk we are willing to take. The Sharpe ratio, developed by William Sharpe in 1966, is a commonly cited metric in virtually every financial sector. It combines the amount of risk we are willing to accept for the expected light at the end of the tunnel (aka profit). With this in mind, let’s take a look at the 25 coins that Samsa currently offers on its trading platform:
Keep in mind that at the time of this analysis (mid-August, 2018), cryptocurrency has been in an 8-month long bear market but has actually entered its lowest volatility era in 14 months. The chart above, which I created using Samsa’s provided metrics on their website, uses daily data from the previous 90 days of each respective coin’s market performance. During this past 90-day stretch, all coins on this list have lost anywhere between 0.2% and 1.3% of their values per day. Yep, not fun at all for us investors. We can see the return per day metric represented by the yellow area toward the bottom of the chart.
At the same time, the volatilities (percentage range between highs and lows) of these tokens have wavered from anywhere between 3.2% in Bitcoin’s case and 8.2% in Nano’s case. This means that over these past three months, Nano has been a hair over two and a half times as volatile as Bitcoin. Represented by the blue area in my chart, we can see that this difference is quite significant.
So with the knowledge that cryptocurrency has been hemorrhaging its value away more days than not for these past three months (and the majority of 2018), it would be safe to presume that Bitcoin has held up the best since mid-May, right? Well, surprisingly not. It is correct to assume that the least volatile coins will tend to hold up the best during negative return timeframes, but there are exceptions that may still thrive or stay on pace with safe haven coins during tumultuous times. As we can see from the chart, this was the case for Stellar (XLM), Ethereum Classic (ETC), and 0x (ZRX).
In spite of heavy volatility, we can see from the Sharpe ratio’s grey line (which coins are sorted by from best to worst), that these three coins have higher ratios due to their microscopically better returns per day despite rockier volatility. In general, looking at these kinds of metrics and charts can really help traders understand that each coin comes with its own quantitative measurement of risk. And depending on that risk, it is vitally important to make sure that the potential return is worth it. So instead of basing your investments on which shillers are shouting the loudest and which coins have the most colorful logos, try looking at the Sharpe ratio as a way of gauging whether a coin is worth your time and risk tolerance strategy.
If the volatility of a particular coin really is too worrisome for you and conflicts with your ability to sleep at night, think about it from a mathematical perspective. If a coin’s current fluctuations are about five times as large as a popular stock with an already high beta like Amazon (AMZN), you could always just invest one-fifth in crypto of what you would otherwise in order to counterbalance for the heavier risk. Despite crypto’s enormous potential and ability to change the way the world transacts with each other, the lack of understanding its investment risk is one of the biggest barriers to entry. Only investing what you’re comfortable with and focusing on your returns in annualized returns instead of weekly and monthly is a great way to keep your head straight and make high-quality decisions with all of the choices of coins right at your fingertips.
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