Volatility
Volatility is a statistic that measures the differences between returns of an investment over a given time period: the greater the difference, the greater the volatility. Generally, the higher the volatility, the more risky it is considered to be. Note that volatility refers both to positive and negative moves, but the nature of markets is such that negative moves typically occur more dramatically than positive moves (and, therefore, high volatility is often associated with negative performance).
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Why should I care about volatility?
For markets: High volatility often signals that a market or specific stock might experience rapid price changes within a short period, which can lead to significant opportunities. For example, increased volatility can lead to wider price swings, which might be advantageous for traders looking to profit from quick, short-term movements. Conversely, a sudden increase in volatility can also prompt a market sell-off as risk-averse investors seek to reduce their exposure.
For you personally: Understanding volatility can greatly enhance your personal investment strategy. If you know a stock or market is particularly volatile, you might decide to adjust your investment approach — for instance, by setting wider stop-loss orders to manage risks or by choosing the right time to enter or exit trades to capitalize on expected price movements. Volatility metrics can help you gauge whether your current portfolio aligns with your risk tolerance and investment goals.
The bigger picture: On a broader scale, volatility reflects economic, political, and sector-specific trends and can serve as an early warning system for larger economic shifts. For example, a noticeable increase in market volatility can be a precursor to economic downturns or crises, as it often reflects investor nervousness and uncertainty. Monitoring volatility can provide insights into the health of the economy and various sectors, helping long-term investors anticipate changes in market cycles and adjust their strategies accordingly.
How to tell if a stock is volatile?
A stock with large swings or fluctuations in price in a short period – hitting new highs and lows or moving erratically – is considered more volatile than one with a smooth, steady climb or fall. A more technical approach involves looking at the stock’s beta, which measures its volatility relative to the market.
Types of volatility
There are two primary types of volatility that traders tend to analyze: implied volatility (IV) and historical volatility (HV).
Implied volatility: Often considered a forward-looking metric, implied volatility is derived from the current prices of options and reflects market expectations about future volatility. It predicts the range within which an asset's price is likely to move and is not directly tied to past price behaviors. This makes implied volatility especially useful for options traders as it helps estimate the probability of an asset hitting a certain price point within a defined period. Traders, then, use implied volatility to help determine options’ prices, with higher implied volatility typically leading to higher option prices a.k.a. “premiums”.
Historical volatility: Also known as statistical volatility, it measures how much the price of a security has fluctuated over a specified past period. It’s typically calculated as the standard deviation of price changes. Unlike implied volatility, historical volatility looks backward, providing a record of how volatile a stock has been. It’s calculated using actual past price changes and is generally less predictive of future movements than implied volatility.
Both metrics are indispensable in options trading; IV for its forward-looking insight and HV for its historical perspective. Together, they provide a comprehensive view of a security’s volatility.
How to calculate volatility?
There are different ways to measure and interpret volatility, but a common method is using standard deviation. The standard deviation measures how spread out the data points (stock prices in this case) are from the average price. In simple words, it tells how much a stock price is likely to change on any given day over a specified period. The higher the standard deviation, the higher the volatility.
Let’s say we want to calculate the volatility of the stock price of a fictional company, Delta Dynamics.
Understanding the standard deviation of a stock's price movements provides a quantifiable measure of its volatility. For example, if Delta Dynamics has a standard deviation of $1.21, and its average stock price is $30, we can express this volatility as a percentage to help compare it to other stocks.
Calculating volatility as a percentage
To convert the standard deviation to a percentage:
- Volatility (%) = (1.21 / 30) × 100 ≈ 4%
This calculation shows that Delta Dynamics’ stock price typically fluctuates about 4% from its average price, providing a clear measure of its relative stability or turbulence. Standarization allows investors to compare volatility across different stocks, helping risk assessment and portfolio strategy calculations.
To understand whether 4% is high or low, you can compare it to other stocks, the market overall, or both.
Industry comparison: Comparing Delta Dynamics’ volatility to its industry peers will give you a benchmark. If volatility in the sector ranges between 3% and 7% for example, Delta Dynamics at 4% would appear moderately volatile.
Comparison with market indexes: Historically, major market indexes like the S&P 500 have shown annual volatility around 15-20%. Let’s assume Delta Dynamics’ 4% volatility was a comparable annual figure too: that’d suggest it’s a less volatile stock than the broader market.
What is the Volatility Index (VIX)?
Think of the VIX as the stock market's “fear gauge.” Created by the Chicago Board Options Exchange (CBOE), the VIX is an annualized measure that typically expresses expected volatility in the S&P 500 index over the next 30 days. It reflects investor sentiment and market stress.
A normal level for the VIX is between 13-19. A VIX level of 20 or above indicates that investors expect higher-than-normal volatility over the next 30 days. A high VIX implies a risky market and suggests investors are anxious. VIX values below 20 typically indicate more stable, less stressful markets.
Is volatility the same as risk?
Although the terms are frequently used as if they’re synonymous, they actually have distinct meanings. “Volatility” measures past and potential swings in the price of an asset, while “risk” is a way of measuring the possibility that your investment might lose its value altogether.
Volatility is an important measure of risk, but it's not the only one. Market risk, credit risk, and operational risk are other aspects that can affect an investment’s performance. That is to say, a company with shaky finances – high debts and falling profits – might be a risky investment, even if its stock price isn’t particularly volatile.
Is volatility a good or bad thing?
Volatility isn't inherently good or bad. But it is a double-edged sword for investors. For instance, high volatility might serve you well if a stock you own shoots up in value. On the other hand, that very same highly volatile stock’s sharp price swings can also lead to losses. In the short term, traders might try to use that as an opportunity, aiming to buy stocks at a discount during downturns and sell them during upswings.
