The bitcoin price has historically been volatile and managing investment risk is the key to avoiding another major market sell off.
The day that bitcoin becomes less volatile is the day that mass adoption will begin. Or is it that mass adoption will minimize volatility on bitcoin?
This is one of the most popular debates in our space as market participants try to speculate when the volatile price action of bitcoin will get smoother. Those who know me are familiar with my stance on the subject: Mass adoption should eventually smooth the volatility curve and price swings on bitcoin, but this adoption could increase volatility significantly in the near term, as the expanding ecosystem continues to adjust to the inflow of new market participants.
As the Bitcoin ecosystem grows and evolves, new players continue to enter with different characteristics from one another, something that can bring disruption or even stress in an ecosystem that has been used to a different reality for such a long time.
The Journey Of Bitcoin Price Volatility
Some of the lowest levels of volatility, in fact, occurred during the early adoption stage (2013 to 2017) of bitcoin, when the market cap was below $20 billion and the network was dominated by early believers in a buyers-only market. Then suddenly, volatility struck with a massive sell off that shook the world in 2018 and took many people “out of the market.”
But what happened prior to the sell off that triggered that event? Many things have been said about this, but few approaches have acknowledged a key event that took place a little earlier, in December 2017: the introduction of the first bitcoin futures product, which started trading on the Chicago Mercantile Exchange.
This was an event that for the first time created a new reality. The ability to short-sell bitcoin on a large scale. In other words, the ability to sell bitcoin that you had never previously owned (even if that bitcoin was never real, but rather just a price tracker).
That consisted of the first expansion of the Bitcoin ecosystem, which came to counter the prior reality of a buyers-only market.
The growing popularity of bitcoin as an asset class on its way to mass adoption triggered the creation of the futures market and the creation of a new type of market participant, the short seller, something that led to a sell off we all remember.
Moving forward, as bitcoin entered a new market cycle, the pain of 2018’s sell off took most momentum players out of the system and allowed the maximalists to regain the majority composition of the network.
Something that led to the gradual rejuvenation of prices all the way through mid-2020, when bitcoin became, for the first time, the coolest kid in town and mass adoption started to seem like a potential reality.
A Deeper Dive Into The Causes Of Bitcoin Price Volatility
But, before we address the present, let’s take a look at how volatile bitcoin was as it headed toward the CME listing, the price ease and the return to relativity for people outside the network.
Bitcoin was quite volatile, some might say, as the network was preparing itself for mass adoption. But how does this compare to the price action of mid-2020 to the present, when a record inflow of market participants joined our network and mass adoption began to start getting triggered?
The record inflow of new market participants led to record volatility in the network, a volatility that does not seem ready to leave the system yet. “Why?” you might ask. “Did we not always believe that mass adoption will bring balance in the system?” “How come bitcoin, at a $100 billion, $300 billion or even $1 trillion market cap, is more volatile than bitcoin at a $20 billion market cap?”
The answer is simple: The market participants now have different utilities and purposes than they did in the early adoption stage, and the network is having a small shock as it is trying to absorb the growth, similar to acne on a teenager’s face as their body grows into that of an adult.
Bitcoin with a market cap in the hundreds of billions of dollars has many new players. Players with different roles and beliefs, with the maximalists accounting now for a significantly smaller part of the pie. The ecosystem has evolved from a buyers-only market that welcomed initially long-term investors, to welcome momentum traders and speculators, proprietary desks and liquidity providers, lenders and a series of other new roles that are in fact very much needed for the long-term purpose of mass adoption, but who have brought extreme volatility in the near term as the network tries to adjust to the new, constantly-evolving reality.
The Importance Of Risk Management
All of that, as one question continues to dominate the market: How can we minimize volatility on a network that has grown from an infant into a baby, but still has a long way to go until it’s fully developed?
The answer is simple: risk management.
Risk management from an individual perspective is the most significant assistance that each of us can offer to bitcoin in order for it to continue to grow and accept new members under lower volatility and smoother price swings.
When it comes to risk management, the number-one rule is understanding your risks. But before we understand them, we actually need to acknowledge them.
“Denial of risk refers to cognitive ways to develop adaption to risky behaviors by rejecting the possibility of suffering any loss.” –Peretti-Watel
“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” -Mark Twain
What if the accumulated total of the bitcoin positions in the world were not based on random outcomes, but instead on scenarios known ahead of the position establishment?
What if the liquidation of that leveraged position could have been prevented?
What if the profit of a miner was locked one year out ,or 70% of the value of your portfolio was secured?
Then confidence would dominate the market and the next sell off would not have been as bad as the prior one.
Risk management is a vote of confidence in bitcoin.
Why? Because confidence is derived by known outcomes and known outcomes are an output of risk management.
Risk management is the answer to extreme volatile swings and lesser sell offs. The moment the downside is not detrimental to our portfolios or lives’ savings, is the moment that liquidations will be avoided and panicked selling will seize.
The moment everyone individually manages their risk is the moment that price normalization will be attained and confidence will be achieved in the broader market.
But how do we even approach risk management?
For starters, risk management begins with position placement and trade execution. Or by simply avoiding an overleveraged situation that you have absolutely no control over.
Risk management occurs by making sure that we do not engage in a trade that, if gone wrong, will threaten the financial wellbeing of ourselves and our families.
Risk management occurs when you put a stop loss on your leveraged position instead of doubling down or hoping that prices will return back to where they were.
Risk management occurs when you quickly realize that you are the one who is wrong, not the market, and accordingly adjust your exposure.
In a more moderate approach, risk management can be achieved through the derivatives markets, when you buy a put option in order to establish a maximum loss scenario or a minimum gain. Or simply when you sell some futures contracts for part of your physical position in order to protect your portfolio against nearby volatility and potential adverse market conditions.
Just like anything else in life, risk management should work as a damage-aversion mechanism, not as an aftermath solution. Our goal should always be to avoid our house catching on fire, not putting the fire out once it’s too late.
This is a guest post by Anestis Arampatzis. Opinions expressed are entirely their own and do not necessarily reflect those of BTC Inc or Bitcoin Magazine.