We need to talk about volatility and how it affects pairs trading in the cryptocurrency market. So,what is crypto pairs trading? Why do we need to focus on learning how different types of digital assets correlate to one another?
Defining volatility in financial markets
The encyclopedic description of this term is quite dry. Financiers say that market volatility is a degree to which price action varies over time. It is usually denoted by the “Sigma” letter of the Greek alphabet in finance and can be measured using mathematical approaches like standard deviation. Some analysts prefer a more complex measurement tool — logarithmic returns.
Regardless of which method you use, the resulting metric will be imperfect, but both approaches give analysts something to work with.
There are many types of volatility that can be used in fundamental analysis, risk management, and many other aspects of investment analysis. For example, when you try to predict price movements and estimate the profitability of any given pairs trade, you can use the so-called implied volatility that uses historical data to extrapolate changes in the future.
Volatility matters for retail traders interested in building consistent strategies that can be effortlessly automated. It is also a hugely important metric for financiers who work with statistical arbitrage since they need to understand potential future changes in price action.
Understanding crypto pairs trading
There are two definitions of pairs trading employed by cryptocurrency investors. Which one they use depends on what they understand under the word “pair” and how deep their knowledge about investing is.
1. The first definition is a type of a relative value trade that aims to create two market positions on price-correlated assets. The idea is to find an undervalued asset and buy it while shorting an overvalued asset at the same time.
2. The second definition is a type of trade conducted with any cryptocurrency pair including standard ones where a base asset is compared against fiat or stable coins. It is a very wide description that covers all types of trading pairs on the spot market.
While volatility as a factor is relevant to both approaches, the first one requires a very specific application of the metric. Crypto pairs trading can be very complicated since you need to work with a myriad of digital assets and once and look for relations between prices. When such a connection appears, it is important to identify the direction of the market and the potential change in volatility to make an informed decision.
Which trading strategies suffer from volatility?
The simplest answer is all of them. Well, triangular arbitrage can be exclusion in some cases. However, most trading systems have to account for volatility. Some retail traders say that volatility is great for scalping, but it is not about the volatility magnitude, but its very existence. Volatile ecosystems give you more chances to make money than those that do not have any significant volatility.
Here are some examples:
· Correlation trading is an approach where an investor tries to identify similarities between asset groups and predict its general direction. Usually, a group is an index or a collection of stocks that can be traded together. An analyst tries to see the difference between the implied volatility derived from analyzing the history and actual volatility. Here, any change in price dynamics can be a huge factor.
· All hedging strategies require traders to conduct a thorough risk management routine before finalizing the portfolio. The problem with the cryptocurrency market is the wide range of market inefficiencies that prevent analysts from assessing the actual market price of any given digital asset. Some assets have limited liquidity on certain exchanges making it even harder to estimate risks associated with any trade.
It is close to impossible to make a perfect analysis without having some industry insights and connections with people who see the bigger picture. Market conditions change rapidly and the volatility can be quite brutal during some periods creating a unique market that relies almost fully on technical analysis.
It is a good thing for contemporary retail traders who understand the value of strategies that can be easily automated with the help from companies like WunderTrading which offer a wide range of preset solutions and customizable bots. However, the cryptocurrency ecosystem can be quite challenging to navigate for newcomers who do not understand some benefits of volatility.
In conclusion
Market volatility is an extremely important metric for any investor who wants to make informed financial decisions. Understanding the intimate connection between volatility and outcomes of certain strategies allows retail traders to build well-performing automated trading systems, sophisticated sets of finely tuned technical indicators, and more.
Whether you want to engage in pairs or correlation trading, you need to understand the impact of volatility on the future direction of the market.
