What Makes Cryptocurrency So Volatile

14 March 2023, 02:01

What Are The Reasons For The Volatility In The Crypto Market

Cryptocurrencies or digital currencies are the future of money. These are fast and secure methods of transaction, free from any government control or interference. At the time of writing, the global crypto market cap is $1.2 trillion, a -39% change from 2021.

Cryptocurrencies are high-risk, high-return investment assets, and trading them requires a great deal of analysis and understanding of the underlying technology and market drivers.

Cryptocurrencies are volatile by design. Cryptocurrency markets are highly speculative and there is no established regulatory regime for trading them. As a result, trading cryptocurrencies is generally more unpredictable than trading stocks and bonds. This volatility can be a good or bad thing, depending on an investor’s perspective. For example, if you bought Bitcoin it was worth $20 in 2011 and held them until they hit $20,000 in 2017, you’d have made 1,000 times the return!

On the other hand, if you bought Bitcoins when they were worth $10,951 in 2018 and sold them for $3,847 in 2019, you would have lost about 70% of your investment. This raises the question:

What factors contribute to cryptocurrency price movements?

cryptocurrency bitcoin above a trading chart

1. Supply And Demand

To understand the volatility of cryptocurrencies, it is important to understand how their supply changes as more people buy them and how mining continues to create new coins. As more people want to buy Bitcoin or Ethereum, those coins will increase in value as demand has increased. Specifically in the case of Bitcoin, there is a limited supply of 21 million BTC hard-coded into its blockchain, so prices will increase even faster as supply stagnates while demand increases. However, because cryptocurrency miners can turn their mining rigs on and off depending on how profitable it is to mine, supply never really strays far from demand. 

2. Speculation And Hype

One of the major contributing factors to cryptocurrency price movements is speculation and hype. When a new cryptocurrency is launched, it usually experiences initial excitement when people first hear about it. This often causes people to rush to buy and sell new coins, pushing the price to unsustainable levels.

This can happen due to several factors, including marketing, rumours, or just plain chance. 

Once people consider the coin overvalued and lose money on it, the hype and speculation dies and eventually leads to a price collapse as the bubble bursts. It is quite common for cryptocurrencies to experience massive spikes and then crashes. 

Influencers and celebrities can also contribute to cryptocurrency price movements. For example, Dogecoin plunged around 30% after Tesla founder Elon Musk called it a “hustle” on his debut appearance on SNL in May 2021.

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3. Production Cost

The cost of token production depends on two main factors:

network hashrate and network energy consumption. In a proof-of-work system like the one used in Bitcoin, miners compete to solve complex mathematical problems to be rewarded with new tokens. The more competition there is to mine a certain cryptocurrency, the harder it will be to mine it and the less profitable it will be for miners who continue to mine it.

Often, miners will give up and switch to another cryptocurrency when their mining efforts no longer pay off. This creates short-term volatility in cryptocurrency prices as miners switch to more profitable tokens or hold tokens longer. This volatility can even affect the long-term success of certain tokens and cause them to lose market share over time.

Therefore, as the cost of mining increases, it follows with an increase in the value of the cryptocurrency, excluding other factors like market sentiment. Miners will not continue to mine if the value of the coin they are mining is not high enough to cover their costs. Bitcoin mining is a great example of this, with prices adjusted to an extent to suit miners.

bitcoin gold coins with ETF

5. Government Actions And Regulatory Shock

While cryptocurrencies are technically free from central bank and government intervention (for example, by changing the supply) there is nothing to stop the authorities from regulating how people can trade or deal with cryptocurrencies. This includes deciding on whether cryptocurrencies are regulated as commodities, currencies, or securities; to outright bans.

For example, China banned Initial Coin Offerings (ICOs) and froze trading in a number of cryptocurrencies back in September 2017, causing the price of Bitcoin to drop significantly over a period.

However, not all government actions are negative for cryptocurrencies prices. Crypto-friendly legislation can also support their value. For instance, BTC got a boost when Salvadoran President Nayib Bukele announced the cryptocurrency as legal tender in El Salvador, passing a law that saw, among other things, the acceptance of the digital currency for tax payments.

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6. Crypto Whales

Crypto whales are great crypto holders. They usually have a large amount of cryptocurrencies and coins at play and can move the market significantly by buying or selling large amounts of crypto. For example, if a person has the fourth largest bitcoin wallet in the world and decides to cash out on a significant portion of their bitcoin, it can cause the bitcoin price to fluctuate significantly in the short term.

Final Thoughts

In conclusion, trading cryptocurrencies can involve quite a high risk because of its highly volatile nature. It requires a great deal of analysis and understanding of the underlying technology and market drivers in order to be better at trading crypto, however there are still many reasons why people choose to trade cryptocurrencies despite their high risk and volatility and you can check them out here.

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