There’s no way to avoid the word “volatility” if you’re even remotely connected to the stock market. It’s a word that suggests potential unpredictability or danger. But is it all bad? And how do you measure volatility in the stock market? Learn all about that and more in this article.
What is stock market volatility?
A stock has increased volatility if its price makes rapid swings between highs and lows. Stocks are less volatile when their prices move slowly or remain relatively stable.
Volatility is, therefore, the rate of fluctuation in prices during a specific period of time. And stock market volatility is a measure of the rate of change in the price of a stock. Volatility—irrespective of the market—thus indicates the risk involved in investing due to price fluctuation.
While market volatility does indicate risk, that need not always translate into losses. Experienced traders, for instance, can use options contracts to benefit from market volatility.
What drives stock price volatility?
The stock market’s volatility is the result of a wide range of factors. A few of the key ones are:
- Demand and supply: The connection between demand and supply and volatility is relatively obvious. When a stock is hyped up in the media, for instance, the demand increases rapidly, leading to volatility.
- Geopolitical factors: Various political events—from elections to wars—in a region can have a tremendous impact on investors and stock prices.
- The state of the economy: Similarly, the economic decisions a government takes and the economic data—from inflation to job data—in a region are key factors.
- Industry, sector, or company-specific issues: Volatility may have to do with events that pertain to the specific industry, sector, or company. A major weather event in an important oil-producing region, for example, may cause prices in the sector as a whole to rise. A company’s performance may also be a key factor.
How is volatility calculated?
Stock market volatility is the standard deviation of annualized returns over a specific time frame. A wide range of prices would be indicated by a greater standard deviation value. On the other hand, a small value for the standard deviation suggests that prices are moving in a small band.
Past market prices determine “historical volatility.” The price of a derivative, such as an option, is used to determine “implied volatility.” That is, how the price might move in the future.
Other volatility quantifiers
As a trader, you can check volatility in many different ways—not just standard deviation and variance, as discussed so far. Here are a few examples.
A stock’s beta compares a stock’s volatility compared to the entire market. It indicates the degree to which its return volatility compares to that of its benchmark index.
So if the beta is 0.8, the stock price moves by 80% for every 100% change in the Nifty 50 index. This indicates that the stock is highly volatile.
When the beta value is high, it indicates that the stock is highly volatile and very sensitive to market changes.
The beta value depends on trader expectations regarding individual stocks as well as the market as a whole.
Options pricing and volatility coefficient
Options traders are hoping for reliable price moves. So high volatility will result in higher options premiums. Because of this, pricing takes implied volatility into account.
Option pricing is the trading price per share. Affected as it is by volatility (among other factors, the pricing uses a volatility coefficient. The volatility coefficient is a percentage derived from daily trading activity.
The CBOE Volatility Index, also known as VIX, relies on the implied volatility of the 30-day options contracts on the S&P 500.
Generally, the VIX goes up when stock prices go down, and vice versa.
VIX is also referred to as the “fear index.” Because it can measure market sentiment. Higher VIX values indicate greater market volatility and fear among investors. And vice versa.
Volatility can mean opportunity
While volatility can sound scary, it need not be a bad thing. It can mean opportunity if you know when to enter and exit the market. In the most straightforward way, you profit by entering/buying in when the prices drop and exiting/selling when the price is high. But that’s not all there is to it.
With speculative trading, traders can go home with huge profits by studying volatility. The better you are able to predict short-term price moves, the higher your profits.
The importance of taking a long-term view in the face of volatility
Investors working with a long-term horizon can afford to be less concerned with volatility. Here are three reasons why a long-term investment strategy helps.
Timing the market is difficult
Every trader tries to time the market, but not everyone is successful. Those who aren’t risk losses. The effects of bad timing can be much more harmful in times of volatility. That’s why investors could benefit from a long-term strategy.
Best days have a big impact
Investors who don’t hold on to their purchases may exit prematurely and miss out on the best days. So it’s important to stay invested when markets are volatile. A long-term investment helps you do that.
Good companies need time
Companies with strong fundamentals tend to do better during market volatility. But it is important for investors to give the company the time it needs to grow. They need to trust that even if it takes a while, the goodness will ultimately be reflected in the stock price. In the meantime, to hold on, a long-term strategy will help.
Volatility is a measure of the extent and speed of price fluctuation over a specific period. Some investors may think of it as a negative thing. So increasing stock volatility often indicates investor anxiety. However, day traders can profit from fluctuations if they enter as well as exit trades right. Taking a long-term horizon also helps.
What is a good volatility for a stock?
A moderate level of volatility, neither too high nor too low, is often considered good for a stock. It provides opportunities for returns while managing risk effectively.
What if volatility is high?
High volatility indicates greater price fluctuations, increasing both potential gains and losses. Investors may experience increased uncertainty and should carefully assess risk tolerance and investment strategies.
Is low volatility good for stocks?
Low volatility in stocks is generally considered favorable. It may offer more stable returns, reduce risk, and provide downside protection, making it attractive for investors.
What is an example of volatility?
Volatility in the stock market is exemplified by rapid and unpredictable price changes. For instance, a stock with frequent and significant price fluctuations showcases high volatility.