What is volatility?

What is volatility?

Volatility, in simple terms, reflects the level of price movement within a given period. Mathematically, it’s a way to assess how much the returns of a particular security or market index vary. This variability is often calculated through standard deviation or variance.

When a price shifts dramatically within a short timeframe, reaching new highs or lows, it’s considered highly volatile. In contrast, if price changes are gradual or the price stays steady, volatility is low. Generally, high volatility indicates a higher risk for that security.

Volatility is gauged using either standard deviation or beta. Standard deviation captures the extent of price variation, while beta measures a security's price changes relative to the broader market, calculated through regression analysis. In more detail, we covered the volatility in article there.

The Importance of Liquidity and Volatility For Traders Source: centerpointsecurities.com

There are two main types of volatility: historical and implied. Historical volatility is derived from past price data and offers insights based on previous trends, though it doesn’t predict the future direction of prices. Implied volatility, on the other hand, projects future price swings by assessing the current market price of a derivative, like an option. This form of volatility is crucial in option pricing as it suggests potential future price fluctuations.

What drives volatility?

Right now we know the two main measures of volatility, but are there any others? Yes, there are special cases.
Several elements influence stock market volatility and the volatility of individual securities:

• The supply conditions within a country or globally
• Economic and sand demand balance for securities
• Geopolitical and social factors
• The approaching expiration date of options contracts

With an understanding of volatility and its causes, let’s look at how it’s calculated. A straightforward way to measure a security’s volatility is by finding the standard deviation of its prices over a certain period. Here’s the step-by-step process:

1. Collect historical prices for the security.
2. Calculate the average of these prices.
3. Find the difference between each individual price and the average.
4. Square each of these differences.
5. Add up all the squared differences.
6. Divide this total by the number of prices (this gives the variance).
7. Take the square root of the variance to find the standard deviation.

Beta

Beta (β) is a metric that reflects how a stock’s volatility compares to the broader market. It measures how much a stock’s returns fluctuate in relation to a benchmark, typically the S&P 500. For instance, a stock with a beta of 1.1 has historically moved 110% for every 100% shift in the benchmark.
On the other hand, a stock with a beta of 0.9 has moved 90% for every 100% change in the underlying index. More details how its count you can read here.

The VIX

The Volatility Index (VIX) offers another way to observe market volatility, quantifying the expected level of stock market volatility.
Developed by the Chicago Board Options Exchange, the VIX estimates the expected 30-day volatility of the U.S. stock market based on live quote prices for S&P 500 options. It essentially represents market expectations on future price direction, reflecting investor sentiment and market risk. A high VIX reading signals heightened market risk.
Traders can engage with the VIX through various options and exchange-traded products or 
utilize VIX levels to inform the pricing of certain derivatives.

Why volatility matters?

Risk as an Indicator

Risk varies in type, but assets with higher volatility are typically seen as riskier because of their more dramatic price swings.
Since investors generally lean toward being cautious, they may prefer low-volatility assets to avoid the stress of unpredictable price movements.
However, it’s important to remember that high volatility can be a double-edged sword. While it can lead to sharp declines, it can also offer the chance for significant gains.

Opportunity

Volatility can present trading opportunities, as it increases the frequency of price changes that traders can leverage for potential profits.
When volatility drives more trading activity, it can boost liquidity, which is beneficial because it narrows bid-ask spreads.

Effect on Asset Allocation

An asset’s historical or anticipated volatility often influences how it fits within a portfolio. Risk tolerance plays a crucial role in portfolio design, with some investors being more open to high-volatility assets than others.
Certain assets, like penny stocks, may exhibit extreme price swings that make them unsuitable for more conservative investors.

In summary, understanding volatility is crucial for traders aiming to manage risk and leverage opportunities across markets. Volatility brings both potential gains and risks, so it’s essential for investors to use well-thought-out strategies to navigate these fluctuations effectively.
Whether you’re new to investing or highly experienced, staying informed about volatility helps in making sound decisions and reaching financial objectives.

Volatility is the key reason why it is possible to make money in financial markets. At the same time, this is the key reason why they can also be lost there. Every market participant – regardless of whether he is a trader or an investor – must take into account its unavoidable impact and look for ways to tame it. If you don't tame it, it will definitely tame you. And only when volatility becomes a friend of your strategy and not an obstacle, will you be able to systematically increase your funds.,
- Vladyslav Pertahia, Head of Front Office at Fondexx