Volatility preference” as a Reason for Bitcoin Growth
Considering the risk-return preference of the traditional investor, the goal of maximizing expected return should be accompanied by the goal of minimizing risk. The volatility of asset return serves as the proxy of risk and, since it has an exogenous nature (consequence of market shocks, i.e. news), it’s essential to have an intuitive understanding of the link between volatility and risk.The most generally accepted idea is that the volatility of return tends to react asymmetrically to “bad” and “good” news. After the release of bad news, the volatility of returns often increases exponentially and lasts longer than with the release of positive news.
In the stock market, this pattern is entrenched in the saying “the market goes up the stairs but goes down in the elevator”. If we take a stock as an example of an asset, the explanation of this pattern may look like this:
The market experiences a negative shock.
The Stock price falls.
Market capitalization of the stock decreases and the share of bonds increases in the capital structure. Capital structure is defined as shares + bonds.
Consequently, the risk of holding those shares increases.
Thus, if the increase in volatility is associated with ‘bad news’ it’s a reasonable assumption that traditional investors may avoid the stock.
The first models investigating the clustering of volatility such as ARCH and GARCH revealed this drawback, which led to the creation of improved models like EGARCH. EGARCH allows the inclusion of an asymmetrical response to differing shocks, showing that it models the behavior of volatility much more effectively.
For some traders however, increased volatility may be preferred as opposed to being undesirable. For example, when using some simple option strategies such as straddle, increased volatility could positively affect profitability. Due to this, its only logical that some traders may be attracted towards non-traditional asset classes, including cryptocurrencies.
The recent capitulation of world central banks attempting to normalise monetary policy (declaring a pause of indefinite length) was probably one of the reasons for the synchronized inflow into the cryptocurrency market. Just this Tuesday saw a surge in popularity to the tune of $100 million, through Coinbase, Kraken and Bitstamp.
Some analysts believe that the policy of world central banks have the potential to rescue the cryptocurrency market from oblivion for a while, i.e. will become the main medium-term driver of cryptocurrency appeal.
One advantage that cryptocurrencies have in the ideological war between fiat and digital currencies, is due to the relative failure of Central Banks policy. For example, the concomitant renewal of the authorities’ interest in the blockchain, or the willingness to make concessions in their legal use, remains at just curious speculation.
If we consider volatility as a stationary process (returning to the long-term average) we can apply it to the price movement of BTC. The volatility of BTC returns were almost at historical minimum in March, before a sudden a surge of activity came along – as highlighted in the graph below.
The behavior of volatility in response to positive market shocks in non-traditional assets should now be different from the behavior of volatility in the traditional securities. This is firstly because the cryptocurrency market threw off its main speculative burden. Secondly, the standard methods of fundamental valuation of assets are inapplicable here. After all, what makes BTC a security? Thirdly, traders’ preferences are completely different here. Consequently, there are no reasons for the rejection of volatility similar to the example explained earlier in this article.
The fundamental reason for growth is still unclear. However, the coordinated movement of prices on three major exchanges, where purchases of 7,000 BTC on each exchange in one hour, suggests that this was the realisation of a pre-conceived plan. It is also curious that the daily trading volume of Tether was around the same volume as in BTC:
Obviously, the market growth was led by the BTC/USDT pair. It is also worth mentioning that Tether updated their main page, stating that each coin is backed with traditional currency, cash equivalents and other company assets.
Strong market movement was accompanied by many traders hitting their SL, trend following within crypto and the expiration of a large amount of put options on the Deribit. On Tuesday the trading volume on the digital derivatives stock exchange jumped to $40 million! This clearly indicates how important it is when analysing market sentiment, to not underestimate the impact of the derivatives market on the underlying asset.
We’re always looking to carry on the conversation, so get in touch and let us know what you think about the appeal of Bitcoin volatility!
Please note that this material is provided for informational purposes only and should not be considered as investment advice. Trading in the financial markets is very risky.