What causes crypto market volatility: how to mitigate risk

If you’re a crypto trader, you should be no stranger to market volatility. From Fed meetings to mass liquidations, there’s a whole list of factors that can trigger significant price swings. This is further amplified by how nascent the crypto market is when compared to traditional financial markets. Curious as to what causes volatility in the crypto markets? Read on as we cover contributing factors to crypto market volatility and how you can mitigate risk as a crypto trader in these uncertain times.

TL;DR

• Market volatility can often lead to amplified price swings due to the nascency of the crypto market.

• When it comes to macroeconomics, crypto market volatility is often caused by factors like interest rate changes, inflation rates, and geopolitical tensions.

• Risk mitigation strategies include ensuring sufficient liquidity, hedging with derivatives, and making use of stop-loss orders to protect trading capital.

What is crypto market volatility?

Crypto market volatility refers to the rapid and unpredictable fluctuations in cryptocurrency prices over a short period. Driven by a combination of factors including speculation, market sentiment, regulatory changes, technological advancements, and economic conditions, crypto prices tend to exhibit larger swings compared to traditional assets. This volatility ultimately presents both opportunities for substantial gains and the risk of significant losses.

Factors affecting crypto market volatility

Interest rate changes

Monetary policies implemented by central banks can significantly impact overall market sentiment and trader behavior.

By hiking interest rates, crypto markets may experience volatility as risk-averse traders may seek to unwind their risky trades in favor of capitalizing on risk-free assets like treasury bills.

Conversely, interest rate cuts may cause traders to adopt a risk-on approach by trading riskier assets since money becomes cheaper to borrow in the form of lowered overall interest rates.

Inflation rates

The relationship between inflation and crypto prices can be complex given the intricacies of inflation itself.

A fiat currency facing an inflationary period often sees its purchasing power decrease. Since most cryptocurrencies (apart from stablecoins) aren’t pegged to fiat currencies, some traders see crypto as an "uncorrelated asset class", and therefore a potential hedge against this loss in purchasing power. This may be why some countries facing inflationary headwinds have a strong appetite for crypto trading.

On the other hand, while inflation can increase demand for cryptocurrencies as a hedge, it can also lead to broader economic uncertainty and risk aversion, which can negatively impact the crypto market as traders adopt a risk-off approach.

Geopolitical tensions

Global conflicts, trade disputes, and political instability can create general uncertainty and volatility in financial markets. Unfortunately, the crypto market isn’t spared from these shocks. Geopolitical events can often trigger fear and risk aversion, leading to sell-offs and price declines.

On the opposing end of the argument, some cryptocurrencies might be perceived as safe-haven assets during times of geopolitical turmoil, attracting investors seeking to diversify their portfolios.

Why is the crypto market crashing?

While crypto market crashes can be triggered by various factors, including algorithmic trading errors and large-scale liquidations, the recent August crypto flash crash appears linked to the unwinding of the Japanese Yen carry trade.

In a nutshell, this arbitrage trade involves borrowing cheap Yen at near-zero interest rates to trade higher-yielding assets. Unfortunately, after the Bank of Japan unexpectedly raised interest rates, the Japanese Yen carry trade is likely to become less lucrative.

To protect their trades and avoid escalating losses, many traders have been forced to liquidate positions across asset classes, including cryptocurrencies. This mass selling has amplified market volatility and contributed to the sharp decline in crypto prices. The rapid unwinding of carry trade positions, coupled with broader economic uncertainties like high unemployment in the US, has eroded the previously bullish market sentiment, exacerbating the sell-off and creating a challenging environment for global asset markets.

Now that we’re aware of why crypto is crashing, it’s essential to create a trading plan off this volatility and understand the possible courses of action crypto traders can take when markets are down.

Risk mitigation strategies

From hedging with crypto derivatives to taking advantage of stop-loss orders, here are some possible risk mitigation strategies to tackle the crypto market crash head-on.

Ensuring sufficient liquidity to prevent margin calls

After celebrating a successful trade, the last thing you’ll want is to realize that you were liquidated during the massive market volatility. A margin call occurs when the value of your assets falls below a certain threshold, forcing you to deposit additional funds or liquidate positions. To avoid this, it’s crucial to maintain sufficient liquidity in your account.

Hedging with crypto derivatives

If you’ve deployed sufficient funds to a position but are afraid of further volatility, you can employ a risk mitigation technique that’s known as hedging. This allows crypto traders to enjoy downside protection while still maintaining the alpha of the original position.

One example of hedging with crypto options is through covered calls. This is a case where you’re already long on a specific cryptocurrency and decide to sell a call option against it. By doing so, you generate additional yield from the call option premium while keeping your original long position. Although this limits your upside potential since you’re obligated to sell the long position at the strike price if the option is exercised, this neutral options strategy provides a safety net against potential price declines and may enhance your overall risk-adjusted returns.

Another popular hedging strategy involves buying protective puts. By purchasing an in-the-money put option on the underlying cryptocurrency that you’re currently long on, you gain the right to sell the asset at a predetermined price before the option expires. This strategy offers downside protection as the put option gains value when the cryptocurrency price decreases. While the put option premium is an upfront cost, it can be worth it as a risk mitigation strategy for your long holdings.

Maintaining a stop-loss for your trades

During times of massive volatility in the markets, stop-loss orders are the optimal way to exit a trade while protecting your trading funds. While there’s the possibility of getting stopped out because of the whipsaw price action, it’s better to adopt a long-term approach when trading. This can be accomplished by keeping your losses to a minimum and re-entering the market at a more favorable price after doing your own research. Ultimately, stop-loss orders can allow you to maintain a balance between risk and reward as you protect your capital while trading the crypto market volatility.

Final words and next steps

From grasping what causes crypto market volatility to highlighting potential risk mitigation strategies, we hope this guide has proven useful in overcoming the panic and fear that tends to accompany massive volatility. By understanding the factors that contribute to crypto market volatility, you’ll be better equipped at developing effective trading strategies and managing your overall risk. For more on crypto market volatility, check out our guide to mastering market swings.