Why Volatility Is So Predominant in Crypto Markets, and How to Protect Your Portfolio Against It

With the market capitalization of all cryptocurrencies dipping as a whole by 23% from all-time highs, it’s easy to tell we’re in a bear market. While some believe prices will fall further, others are still more hopeful for a retracement of recent highs. With the U.S. Federal Reserve concluding its two-day meeting on monetary policy this week, markets could see further volatility.

The U.S. dollar is being offset against rising inflation, and digital asset proponents have never been in a better position in terms of optics. CEOs of large organizations like Michael Saylor and Elon Musk have publicly supported cryptocurrencies and blockchain technology, and the adoption of NFTs by famous artists is pushing blockchain technology closer to the mainstream.

So why is the market crashing? Aren’t cryptocurrencies supposed to become more stable with adoption? Shouldn’t Bitcoin’s deflationary model be attracting more investments? Market volatility is a complex and dynamic phenomenon that integrates many moving parts. It’s challenging, if not downright impossible, to keep track of everything. At times, the market might react strongly to even minor factors. 

Despite consistently pushing to new heights, Bitcoin’s wild swings have also led countless investors to experience losses. It has regularly suffered 30-40% drops throughout its decade-old history. Theoretically, Bitcoin’s prices should stabilize as more money is invested into the network. However, real-world markets don’t always adhere to theoretical ideals.

Crash and Effect

There are countless articles online detailing how Bitcoin derives its value, but cryptocurrency markets are still heavily built on sentiment. Though the number of use-cases for Bitcoin is making swift progress, there’s still no clear-cut method to link Bitcoin to a specific price, and this makes the asset class painfully susceptible to changes in market sentiment.

Cryptocurrency traders also have unusual access to large amounts of leverage. Though this enables clever traders with less capital to make huge gains, it can cause a cascade of market-wide losses when prices crash.

The variation in regulation doesn’t help either. Though regulatory bodies are making efforts to create better legal frameworks for the asset class, countless cryptocurrencies have seen their growth dismantled by tightening governmental policies. Further, cryptocurrencies don’t explicitly respect international borders or agencies of government, presenting additional problems for lawmakers who are accustomed to dealing with better-defined assets.

Limiting Risk

Risk-averse investors are always open to exploring ways to hedge their bets. For obvious reasons, closing a position reduces risk since the market’s swings no longer affect your capital. However, this closes your portfolio off to any gains the market may have in store.

In general, traders open positions based on whether they think the market is going up or down. However, many investors hold both long and short positions, especially in volatile markets. Though this can have the effect of muting profits during an upswing, it can significantly protect portfolios against losses should the market spiral downward.

When trading in volatile markets, liquidity is vital. The ability to exchange assets for cash quickly with minimal slippage is a sign of market integrity, without which traders would be unable to change their positions when volatility strikes. It’s also helpful to diversify your portfolio, which is one of the most widely accepted pieces of advice given to newer traders in order to limit risk.

Shorting the market is also an option, so traders sell their assets to buy back in at a lower price. There are quite a few ways to short digital assets, including margin trading, where traders borrow from a broker (with or without leverage) to make a trade. However, the downside of short-selling is that it exposes your holdings to infinite losses. Short-selling the wrong asset at the wrong time can be catastrophic.

Leveraging Risk

Derivative contracts are, by far, the most popular way for investors to hedge their bets. These contracts, as the name suggests, derive their value from the price of an underlying asset — in our case, a cryptocurrency. Futures are derivative contracts that give their holders the obligation to buy or sell the underlying asset at a particular price before a predetermined date.

This is especially useful for blockchain miners, who may need to sell their earnings at a certain minimum price to keep their operations running. Futures are a secondary market for crypto investors, and since market participants can sell these contracts before the agreed-upon expiration dates, they also have significantly higher liquidity compared to spot markets.

However, futures were primarily designed to service securities markets, with fixed expiration periods over the year. Unlike these markets, which open and close at set intervals, cryptocurrency markets are perpetually available, leading to an evolution of futures contracts known as perpetual futures or perpetual swaps. Perpetual swaps are derivative contracts that enable their holders to buy or sell the value of an underlying crypto-asset without any expiration date for holding that position.

Because of this lack of expiration, exchanges impose a funding rate mechanism to anchor the price to the spot price. This works on the principle of incentivizing or disincentivizing trade, using a fee to balance out the demand between short and long perceptual positions.

Traders holding long perpetual swaps pay a fee to those holding short positions when the contract trades below the spot market price. Shorts pay longs when the contract trades above the spot price. Paying or receiving such fees is what keeps the position open. Perpetual swaps afford traders significantly more buying power than regular spot markets, giving them a better chance at dealing with sharp volatility spikes.

Before heading over to your favorite derivatives platform to hedge your spot positions, it’s essential to understand the funding rate mechanism for that particular asset, as well as the potential returns in different scenarios. It’s also crucial to know how leverage works, and how much leverage you have access to on an exchange.

For example, Phemex, one of the world’s top derivatives exchanges by contract volume, offers up to 100x leverage on perpetual swaps. It also recently unveiled its inverse ETHUSD perpetual contract. Using their USD-margined linear contracts, traders can pool their shorting gains in USD to protect against further market downturns. Using their crypto-margined inverse perpetual contracts, traders can accumulate profits in crypto, reeling in more profits through appreciation during bull markets.%20Campaign&_channel_

Despite having no expiration date, perpetual swaps are more suited to short-term hedges. This is because fluctuations in the funding rate can make the cost of hedging quite unpredictable, and losses from highly leveraged positions can quickly outpace gains on the spot market.

Though hedging can help protect portfolios from losses, it isn’t entirely risk-free. When choosing a strategy, it’s necessary to evaluate the benefits and drawbacks of hedging a particular cryptocurrency. In many cases, hedging can be counterproductive especially when markets remain neutral or only move within a set range.

Digital assets are inherently volatile financial instruments that come with their own set of risks. However, by learning more about the various strategies that can be used to mitigate these risks, traders can protect themselves from unnecessary losses produced by sudden market swings.