by Chad Steinglass

To Risk Or Not To Risk?

Volatility Smirks

There’s another measure of risk that the market is fond of, and though it is sometimes a simplistic way to define risk, it can be very useful: volatility. In the vast majority of capital markets, as investors perceive risks to be increasing, we see prices start to decline and we also see volatility tick higher. This 3-sided dance of risk, price, and volatility is a function of the concept of risk premium, and also contributes to the phenomenon of volatility skew as seen in option markets, where downside puts trade at higher implied volatility levels than upside calls. As time moves forward and markets swing around, the states of the world where markets move higher tend to be less volatile, less uncertain, and therefore lower risk premiums. Conversely the states of the world in which markets move lower tend to be more volatile, more uncertain, and therefore trading with higher risk premiums.

Head Over Heels

The above paragraphs describe the ebb and flow of most capital markets, but not all. There are corners of the market where the relationship between risk, volatility, and prices gets turned on its head. Sometimes this happens in commodities, sometimes in particularly hot equities, and certainly in Crypto. In these markets, under the right conditions, investors can be risk seeking rather than risk averse. You can also think of it by turning the concept of risk upside down: in some assets, the risky move is NOT owning them. In this frame of reference, as prices move higher it leads to increased volatility and volume, as the “fear of missing out” trumps the fear of taking losses. When looking at assets that seem to have inverted risk profiles, like crypto, it’s reasonable to infer that they also have inverted, or negative risk premiums. Rather than in a traditional market when prices reflect a discount to “fair” value, the market prices of assets like crypto tend to trade at a premium over “fair” value.

Over the past few months as crypto markets have cooled off, we have seen the dynamics of this type of risk asset playing out. As days have dragged on with no new catalyst or news to drive prices higher, we have seen prices, volume, and volatility all slowly drift lower in concert. This is the hallmark of a hot asset that has cooled off. Just like a normal risk asset that drifts slowly higher with ever decreasing volatility during boring but good markets, these crypto assets are drifting lower with decreasing volatility during this boring but bad market.

What Can Happen Next?

With every day that passes, the risk attributes of crypto, especially blue chips like BTC and ETH, are becoming less inverted and more like an equity or other “normal” risk asset. I believe that this period can last for a while longer, but not likely forever. For the moment, with tight ranges holding firm within a slight but clear downtrend, investors don’t seem to be viewing crypto through the eyes of a risk seeker with inverted risk premium. But for those who have traded crypto markets for any significant amount of time, we know that the wind can change quickly. I, for one, am patiently awaiting a catalyst or market shift that pushes crypto back into a world of increasing prices, volatility, and volume.

The opinions expressed in the CrossTower Classroom are those of the author(s) and not necessarily that of CrossTower. We appreciate diverse perspectives of our employees and we thank them for having a voice.

Share

CrossTower Inc. provides this content for general information purposes, to better inform you on your digital asset investment journey. We do not provide investment recommendations or provide tax advice. Please consult your investment professional or tax advisor if you require assistance in these areas.

Ready to get started?

Subscribe below and get started on your CrossTower journey. We offer a variety of informational content along with our top tier trading services.