Why Volatility Spikes in Crypto Markets and How To Protect Your Assets From It

Volatility Spikes in Crypto Markets

It’s easy to tell we’re in a bear market. The total market capitalization of all cryptocurrencies has dropped by 23% from all-time highs. While some anticipate prices will continue to fall, others feel a retracement in the works. Additionally, this week markets could experience more volatility as the U.S. Federal Reserve wraps its two-day monetary policy meeting. 

Rising inflation is devaluing the U.S. Dollar, and proponents of digital assets have never been in a stronger position in terms of optics. Large-company CEOs like Michael Saylor and Elon Musk have publicly endorsed cryptocurrencies and blockchain technology, while the use of NFTs by celebrities is bringing blockchain closer to the mainstream. 

So, why is the crypto market crashing? Isn’t it true that cryptocurrencies gaining popularity should make them more stable? Isn’t Bitcoin’s deflationary model supposed to encourage more investors? Volatility in trading markets is a complicated and dynamic phenomenon with numerous moving elements. Keeping track of everything can be difficult, if not impossible, with even simple changes to the status quo causing the market to respond violently at times. 

Despite continually pushing to new highs, Bitcoin’s unpredictable fluctuations have resulted in losses for many investors. It has experienced recurring decreases of 30-40% throughout its ten-year lifespan. Bitcoin’s prices should theoretically stabilize as more money is invested in the network. On the other hand, the real-world doesn’t always line up with the theory. 

Sentiment and Stability

Even though numerous publications online have explained how Bitcoin gets its value, cryptocurrency markets are still mainly based on sentiment. Although the number of use-cases for Bitcoin is rapidly increasing, there is still no clear-cut means to link the BTC token to a specific price, leaving the asset class extremely vulnerable to the market’s mood swings. 

Cryptocurrency traders also have very high leverage available to them. Though this allows smart traders with less capital to achieve enormous gains, it can also result in a cascade of market-wide losses if prices drop. 

The lack of consistency in regulation is also a hindrance. Despite efforts by regulatory authorities to build more precise legal frameworks for the asset class, restrictive government policies have stifled the rise of various cryptocurrencies. Furthermore, because cryptocurrencies do not respect international borders or government agencies, politicians who are used to dealing with more well-defined assets have additional challenges.

Remedies for Risk

Investors are constantly looking for new strategies to hedge their bets. Closing a position minimizes risk because the market’s movements no longer affect your capital. This, however, locks your portfolio off to any potential market gains. 

Traders typically open positions based on whether they believe the market will rise or fall. However, especially in volatile markets, many keep both long and short holdings to hedge their investments. Though this may dampen profits during an upswing, it can significantly protect portfolios from losses if the market falls. 

Liquidity is critical while dealing in volatile markets. Market integrity is defined as the capacity to exchange assets for cash swiftly and with little slippage, without which traders would be unable to modify their positions when volatility arises. It’s also a good idea to diversify your portfolio, which is one of the most widely acknowledged pieces of risk management advice for beginner traders.

 Shorting the market allows traders to sell their assets and then repurchase them at a reduced price. Margin trading, in which traders borrow money from a broker (with or without leverage) to make a trade, is one approach to short digital assets. On the other hand, short-selling has the disadvantage of exposing your holdings to unlimited losses. Shorting the wrong asset at the wrong moment can have disastrous consequences. 

Formulaic Finance

By far, the most popular approach for investors to hedge their bets is through derivative contracts. As the name implies, the value of these contracts is determined by the price of an underlying asset, in this case, a cryptocurrency. 

Futures are derivative contracts in which the holder is obligated to buy or sell the underlying asset at a specific price before a particular date. This is particularly important for blockchain miners who may need to sell their revenues at a specified minimum price to keep their business running.

Futures are a secondary market for crypto investors. They offer much more liquidity than spot markets because market participants can sell contracts before the agreed-upon expiration dates.

 On the other hand, Futures were primarily created to serve the traditional financial markets, with scheduled expiration dates throughout the year. Unlike securities markets, which open and close at regular intervals, cryptocurrency exchanges are always open, leading to the development of more advanced derivative contracts – perpetual futures or perpetual swaps. 

Perpetual swaps are derivative contracts that allow owners to buy or sell the value of an underlying crypto asset without having to re-establish their position after a predetermined period. Because of the lack of expiration, exchanges impose a funding rate mechanism to lock the price to the spot price.  

This works based on rewarding or discouraging trade through the use of a fee to balance demand between short and long perceived positions. When the contract trades below the spot market price, traders who hold long perpetual swaps pay a charge to those who hold short positions. When the contract trades above the spot price, shorts pay longs. 

Paying or receiving these payments keeps the position open. Perpetual swaps give traders substantially greater buying power than spot markets, allowing them to better deal with abrupt volatility increases. 

 It’s critical to grasp the funding rate mechanism as well as the potential risks of using leverage before heading over to your favorite derivatives platform to hedge your spot bets. It’s also essential to understand how leverage works and how much leverage an exchange affords you. 

Phemex, for example, one of the world’s top derivatives exchanges by contract volume, offers perpetual swaps with up to 100x leverage.  It also recently announced the launch of an inverse ETHUSD perpetual contract. One low-risk method traders use to grow their holdings is to pool their shorting winnings in USD using USD-margined linear contracts, safeguarding them against subsequent market downturns. Later, however, when the market turns, profits are amassed in crypto using crypto-margined inverse perpetual contracts, raking in even more gains through appreciation. 

Despite their lack of an expiration date, Perpetual swaps are better suited to short-term hedges. This is due to the fact that funding rate swings can make hedging costs relatively unpredictable, and losses from heavily leveraged positions can quickly surpass gains on the spot market. 

Hedging can help safeguard portfolios against losses, but it isn’t without risk. 

When deciding on a plan, weigh the advantages and disadvantages of hedging a particular cryptocurrency. Hedging can be unproductive in many circumstances, especially when markets are neutral or only move within a narrow range. 

Digital assets are inherently risky financial products with their own set of dangers. Traders can protect themselves from needless losses caused by unexpected market fluctuations by learning more about the numerous tactics that can be employed to limit these risks.

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