What is Volatility & How it Affects You?
Financial market volatility is defined as the rate at which the price of an asset rises, or falls, given a particular set of returns. It is often measured by looking at the standard deviation of annual returns over a set period of time.
At its core, volatility is a measure of how risky a particular investment is, and it is used in the pricing of assets to gauge fluctuations in returns. That is, when the volatility is high, the trading risks are higher and vice versa. When volatility is used in the pricing of financial assets, it can help to estimate fluctuations that are likely to occur over the short term.
If an asset’s price fluctuates quickly within a short timeframe, then it is considered highly volatile. An asset whose price moves slower over a longer time period is said to have low volatility.
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Types of Volatility
Volatility is one of the factors that investors in the financial markets analyse when making trading decisions. There are two key approaches to volatility, each with its pros and cons:
- Implied Volatility:
The term implied volatility describes the estimated volatility of an asset and it is a common feature of options trading. Implied volatility reflects how the marketplace views where volatility should be in the future, but it does not forecast the direction that the asset’s price will move. Generally, an asset’s implied volatility rises in a bear market because most investors predict that its price will continue to drop over time. It decreases in a bull market since traders believe that the price is bound to rise over time. This is down to the common belief that bear markets are inherently riskier compared to bullish markets. Implied Volatility is one of the measures that traders use to estimate future fluctuations of an asset price on the basis of several predictive factors.
- Realised / Historical Volatility:
Realised volatility, also known as historical volatility, is a way of statistically measuring how the returns from a particular asset or market index are dispersed when analysed over a given timeframe. Normally, historical volatility is measured by establishing the average deviation of a financial instrument from its average price over a given period of time. Standard deviation tends to be the most common measure of realised volatility, though there are other methods used to calculate this metric. Risky security is one that has a high historical volatility value though, in certain types of trades, it is not necessarily a negative factor since both bullish and bearish conditions could be risky. In relation to these two metrics, historical volatility (backward looking) serves as a baseline measure, with implied volatility (forward-looking) defining the relative values of asset prices.
If the two metrics show similar values, then an asset is considered to be fairly priced on the basis of historical norms. For this reason, traders look for deviations from this equilibrium to establish if assets are overvalued or undervalued.
The Standard Deviation Model of Assessing Financial Volatility
Standard deviation is a measure used to statistically determine the level of dispersion or variability around the average price of a financial asset, making it a suitable way to measure market volatility.
In general terms, dispersion is the differential between an asset’s average value and its actual value. The higher the dispersion or variability, the higher the standard deviation is. The lower the variation is, the lower the standard deviation. Analysts often use standard deviation as a means of measuring expected risk and determining how significant a price movement is.
When calculating the standard deviation of volatility, the variance of a data set of prices of an underlying asset must be derived. The standard deviation is the square root of variance.
For purposes of illustration, we will consider the price of an underlying asset that has rallied uniformly from $1 to $10 in 10 trading periods. Standard deviation will be derived in the following steps:
- Calculate the mean for the 10 trading days. This is done by adding the prices together ($1, $2….to $10) and then dividing it by 10 (in this case, the total number of prices). The sum of 55 divided by 10 will be $5.5.
- Determine the deviation from the mean at each period. This is the difference between the closing price and the mean. For instance, on the 7th day, the price of $7 deviates from the $5.5 mean by 2.5.
- Square the deviation of each period. All the periods with negative deviations will be eliminated by squaring them.
- Sum the squared deviations. As per our example, the sum is $82.5
- Divide the sum by the number of periods, in this case, 10. This will be $8.25.
- The standard deviation is the square root of this number. In this case, the standard deviation is $2.75 which reflects how values are spread out around the average price, giving traders insight as to how far the asset price may deviate from the average.
As the calculation above shows, standard deviation as a measure of risk assumes that the data set follows a normal distribution, or what is referred to as a bell curve.
In such a scenario, as above, 68% of data will fall within one standard deviation; 95% will fall within two standard deviations, and 99.7% of data will fall within three standard deviations. But there are a few limitations to using standard deviation as a measure of volatility.
To start with, prices or returns are never uniform, and they are punctuated by periods of sharp spikes in either direction. This will mean that the standard deviation itself may experience fluctuations depending on the periods that are taken into consideration during the calculation.
There is also the beta (β) method for measuring or calculating volatility. In this method, an underlying asset’s volatility is measured against other related assets. For instance, the volatility of Apple stock can be measured against the overall volatility of other technology sector stocks or even an entire benchmark stock index. Learn more about how this model of volatility assessment is calculated as well as its significance in our risk management guide.
Why Volatility Matters?
Volatility Affects Trader Sentiment
Analysing market sentiment is an essential part of financial data analysis. Prices of assets traded on the financial markets will usually move up and down on a daily basis – a natural effect of the stochastic behaviour of the financial market.
In spite of these price movements, hundreds of millions of investors worldwide continue to risk their money in the financial market, hoping to make returns in the future. The volatility of the financial markets is of interest to investors since high levels of volatility often come with the chance of huge profits or significant losses at the expense of higher uncertainty.
If volatility is extremely high, investors may choose to stay away from the markets in fear of losing their funds. Others might engage in riskier trading in the hope of earning higher profits.
Volatility Affects Trading Costs
Volatility is a fact of investing life, and it guides or affects various decisions that investors have to make in the market. In general, high volatility implies high inherent risk, but it also means high reward opportunity. Money is made out of price changes in the markets, but high volatility carries additional risks as well.
The high volatility witnessed during the release of major economic news and events of underlying assets is a testament to this.
In options trading, high volatility has the effect of increasing premiums (which is essentially the cost of an option contract). This is because of the perceived higher likelihood that a highly volatile asset has of hitting any relevant strike price and thus, expire in the money.
Additionally, volatility can influence decisions on capital allocation and portfolio rebalancing. Typically, less volatile assets will be allocated a higher proportion of capital than more volatile ones. This can trickle down to position sizes with investors likely to trade more volatile assets with smaller lot sizes. Volatile assets can also skew the performance of an overall portfolio, and this may prompt investors to rebalance to achieve stability.
To determine the optimal entry and exit points for trades, one can track volatility in the markets. This can be done using a choice of tools including:
- VIX (CBOE Volatility Index),
- ATR (average true range),
- and Bollinger Bands.
The ticker symbol VIX is the name for the CBOE (Chicago Board Options Exchange) Volatility index often referred to as the fear index or fear gauge. This index measures the stock market’s expectation of volatility based on the S&P 500 index options. Generally, when VIX values are in their low teens, this indicates low volatility whereas a reading of higher than 30 indicates increased volatility in the market.
Developed by J. Welles Wilder Jr., the ATR indicator, or average true range indicator, can be applied to any forex pair, ETF, stock, commodity, or futures contract. This indicator calculates the ‘true range’ and it creates the ATR as a 14-day exponential moving average (EMA) of the true range. To calculate the true range, the highest value generated by one of three equations is used:
- True range = Previous day’s close minus the current day’s low
- True range = Current day’s high minus the current day’s low
- True range = Current day’s high minus the previous day’s close
Low readings from the ATR indicate a ranging market with low volatility whereas a larger ATR indicates increased volatility.
Bollinger Bands, created by John Bollinger, are also a helpful indicator to track volatility in the markets and that can be applied to any commodities or stock chart. It consists of 2 bands or lines which are 2 standard deviations above and below the 20-day moving average. The 20-day MA appears as a line in between the two bands. With increased volatility, the bands will widen and in periods of low volatility, the space between the bands will narrow.
Derivatives Based On Volatility
Besides investments in stocks, currencies or commodities, some traders opt to invest in the concept of volatility itself through a number of derivative investments. These include exchange-traded notes (ETNs), which are similar to ETFs (exchange-traded funds) but are actually unsecured debt notes.
One of these derivatives is VIX, the ticker symbol for the Chicago Board Options Exchange Market Volatility Index. This index serves as a measure of how much traders are willing to invest in buying or selling of the S&P 500 index options.
The VIX is often referred to as the fear index or the fear gauge. The biggest and most popular VIX-related investments are the iPath S&P 500 VIX Short-Term Futures ETN (VXX) which has long positions in futures contracts.
If you would want to trade on financial market volatility or use it as a hedge, then the VIX-related ETNs are acceptable instruments.
Volatility main FAQs
How can I trade volatility?
There are a number of methods used to trade volatile markets, but perhaps one of the most popular is the straddle method. This straddle strategy uses pending orders to take advantage of the volatility that often follows important news releases such as earnings reports from companies, or economic reports from governments. In it a trader places a pending long and a pending short on either side of a consolidating price ahead of the anticipated news event. This allows the trader to capture the resulting move in the asset no matter which direction it takes following the news.
What causes market volatility?
There are a number of theories regarding the origins of volatility in markets and it’s likely that each of them have some grain of truth. It’s been noted before that economic releases and company news cause volatility, as do analyst notes and earnings results. Some have noted that while this is true, the underlying reason for the volatility is coming from short sellers and automated trading robots. One approach claims that volatility is the result of psychological forces in the market, where volatility comes about when there is a massive shift in investor sentiment and/or perception. No matter what causes volatility it is certain that it does exist and traders must find a way to successfully deal with it.
Is it possible to benefit from market volatility?
It is possible to benefit from any type of market if you know how. Experienced traders that have dealt with volatility can tell you there are a number of strategies that can help generate good returns during periods of volatility. One is to start small, and a compliment to that is to be choosy with your trades. Because volatility can cause whipsaws in markets it is also important not to be overconfident, and to be willing to adapt and rapidly change direction if necessary. Take the emotions out of your trading, remain focused, track your trades, and if all you can get are small profits be content with that.
The Final Word
Although some people have a negative view of volatility within the financial markets, it can actually increase the potential for profit if short-term trades are correctly predicted.
Cryptocurrencies, such as Bitcoin and Ethereum, are extremely volatile, but this is exactly what made trading them so profitable over the last few years. Once you understand volatility and how it impacts asset prices, you are then able to benefit from these price movements.
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