Price Volatility

Price Volatility Explained

Price Volatility is a simple concept that exists in and out of DeFi – it is a measurement of the variance in price that an asset experiences over time. Price volatility is typically quoted in daily weekly, monthly, or annual terms. In public equity markets, the VIX is a 30-day volatility index that tracks S&P 500 option price movements. The VIX has been dubbed the “Fear Index”, as higher volatility typically infers higher market risk and a heightened sense of overall stress in the market. Price volatility is a key consideration in lending agreements, both from a collateral standpoint and a borrowed coin standpoint. Loan-to-Value ratios – the amount of collateral necessary for a loan – are calculated based on the price volatility of the collateral. Similarly, the price volatility of a borrowed coin is a key consideration when developing a trading strategy and understanding the risk profile. 

What to Know

In lending agreements, the collateral’s price volatility is a key driver of the leverage multiple afforded (LTV) to the borrower, for example 5X, 10X or 100X. A lender might be more willing to extend a higher leverage multiple if the collateral is a stablecoin. Stablecoins experience virtually no price volatility, as collateral considerations are quoted in USD terms. Whereas a loan collateralized by ETH or BTC is typically subject to a lower leverage multiple. The leverage multiple will have a clear effect on the overall gains or losses of a leverage trading strategy.
The price volatility of the coin being borrowed will impact the leverage trading strategy as well. If the price volatility of the borrowed coin is high, the borrower is at higher risk of being liquidated. Higher price volatility of the borrowed coin can expose the collateral to risk of seizure.

Why it Matters

Price volatility of the posted collateral can have dramatic effects on the terms of a loan and thus on the outcome of a leverage trading strategy. In DeFi, lending protocols set LTV’s. Understanding the terms of the loan before entering a leverage trading position will help set expectations around the strategy’s risk and return profile. It’s critical to monitor the prices of both the collateral and borrowed coins, while executing a trading strategy, in order to avoid collateral exposure, or liquidation.

As DeFi matures, we anticipate derivatives like futures, options and other products will be developed to help defi traders risk manage their trading strategies.