Words for the Week #5 Market Volatility
What is Volatility?
Volatility is a statistical measure of the dispersion of returns for a given security or market index. That usually means, the higher the volatility, the riskier the investment or security. Volatility is often measured by either the standard deviation or variance between returns from that security or index.
In the securities markets, volatility is often associated with major swings in either direction. i.e., when the stock market rises and falls more than one percent over a sustained period of time, it is called a "volatile" market. An stock or market's volatility is a key factor when pricing an option contract for that security.
What does that mean to you?
- Volatility represents how large an asset's prices swing around the mean price—it is a statistical measure of its dispersion of returns.
- There are several ways to measure volatility, including beta coefficients, option pricing models, and standard deviations of returns.
- Volatile assets are often considered riskier than less volatile assets because the price is expected to be less predictable.
- Volatility is an important variable for calculating prices. Usually referring to options.
Volatility often refers to the amount of uncertainty or risk related to the size of changes in a security's value. A higher volatility means that a security's value can potentially be spread out over a larger range of values. This means that the price of the security can change dramatically over a short time period in either direction. A lower volatility means that a security's value does not fluctuate dramatically, and tends to be more steady.
One way to measure an asset's volatility variance is to quantify the daily returns (percent move on a daily basis) of the asset. Historical volatility is based on historical prices and represents the degree of variability in the returns of an asset. This number is generally expressed as a percentage.
While variance utilizes the dispersion of returns around the mean of an asset in general, volatility is a measure of that variance usually within a specific period of time. That measure is generally daily volatility, weekly, monthly, or annualized volatility. Often we refer to that measure of volatility as the annualized standard deviation.
What is Volatility Mathematically?
Volatility is a statistical measure of the dispersion of data around its mean over a certain period of time. It's calculated as the standard deviation multiplied by the square root of the number of periods of time, T. In finance, it represents this dispersion of market prices, on an annualized basis.
How is that volatility calculated?
Volatility is generally calculated using variance and standard deviation (the standard deviation is the square root of the variance). Since volatility describes changes over a specific period of time you take the standard deviation and multiply that by the square root of the number of periods in question:
vol = σ√T
- v = volatility over some interval of time
- σ =standard deviation of returns
- T = number of periods in the time horizon
For simplicity, let's assume we have monthly stock closing priceof $1 through $10. For example, month one is $1, month two is $2, and so on. To calculate variance, follow the five steps below.
- Find the mean of the data set. This means adding each value and then dividing it by the number of values. If we add, $1, plus $2, plus $3, all the way to up to $10, we get $55. This is divided by 10 because we have 10 numbers in our data set. This provides a mean, or average price, of $5.50.
- Calculate the difference between each data value and the mean. This is often called deviation. For example, we take $10 - $5.50 = $4.50, then $9 - $5.50 = $3.50. This continues all the way down to the first data value of $1. Negative numbers are allowed. Since we need each value, these calculations are frequently done in a spreadsheet.
- Square the deviations. This will eliminate negative values.
- Add the squared deviations together. In our example, this equals 82.5.
- Divide the sum of the squared deviations (82.5) by the number of data values.
In this case, the resulting variance is $8.25. The square root is taken to get the standard deviation. This equals $2.87. This is a measure of risk and shows how values are spread out around the average price. It gives traders an idea of how far the price may deviate from the average.
Types of Volatility.
Implied volatility (IV), also known as projected volatility. As the name suggests, it allows one to make a determination of how volatile the market will be going forward. This concept also gives us a way to calculate probability. One important point is that it shouldn't be considered science, so it doesn't provide a forecast of how the market will move in the future.
Unlike historical volatility, implied volatility comes from the price of an security or option itself and represents volatility expectations for the future. Because it is implied, investors cannot use past performance as an indicator of future performance. Instead, they have to estimate the potential of the option in the market. Implied volatility is a key feature of options trading.
Often referred to as statistical volatility, Historical volatility (HV) gauges the fluctuations of underlying securities by measuring price changes over predetermined periods of time. It is the less prevalent metric compared to implied volatility because it isn't forward-looking.
When there is a rise in historical volatility, a security's price will also move more than normal. At this time, there is an expectation that something will or has changed. If the historical volatility is dropping, on the other hand, it means any uncertainty has been eliminated, so things return to the way they were.
This calculation often measures movements based on the change from one closing price to the next. Depending on the intended duration of the options trade, historical volatility usually will be measured in increments ranging anywhere from 10 to 180 trading days.
Other Measures of Volatility:
One measure of the relative volatility of a particular stock to the market is its beta (β). A beta approximates the overall volatility of a security's returns against the returns of a relevant benchmark (usually the S&P 500 is used). For example, a stock with a beta value of 1.1 has historically moved 110% for every 100% move in the benchmark, based on price level. Conversely, a stock with a beta of .9 has historically moved 90% for every 100% move in the underlying index.
Market volatility can also be seen through the VIX or Volatility Index, a numeric measure of broad market volatility. The VIX was created by the Chicago Board Options Exchange as a measure to gauge the 30-day expected volatility of the U.S. stock market derived from real-time quote prices of S&P 500 call and put options.1 It is effectively a gauge of future bets investors and traders are making on the direction of the markets or individual securities. A high reading on the VIX implies a risky market.
Example of Volatility.
We are building a retirement portfolio. Surmise the person is retiring within the next few years, and we are seeking investments with low volatility and steady returns. We are considering two investments:
- ABC Investment. has a beta of .78, which makes it slightly less (22%) volatile than the S&P 500 index.
- XYZ, Inc. has a beta of 1.45, making it significantly (45%)more volatile than the S&P 500 index.
A more conservative investor may choose ABC for their portfolio, since it has less volatility and more predictable short-term value
Tips on managing volatility.
Investors can find periods of high volatility to be distressing as prices can swing wildly or fall suddenly. Long-term investors are best advised to ignore periods of short-term volatility and stay the course. This is because over the long run, stock markets tend to rise. Meanwhile, emotions like fear and greed, which can become amplified in volatility markets, can undermine your long-term strategy. Some investors can also use volatility as an opportunity to add to their portfolios by buying the dips, when prices are relatively cheap. You can also use hedging strategies to navigate volatility.
Is volatility the same as risk?
Volatility is often used to describe risk, but this is necessarily always the case. Risk involves the chances of experiencing a loss, while volatility describes how large and quickly prices move. If those increased price movements also increase the chance of losses, then risk is likewise increased.
Whether volatility is a good or bad thing depends on what kind of investor you are and what your tolerance for risk is. For long-term investors, to much volatility can spell trouble, but for some investors, volatility often equals trading opportunities.
Volatility is how much and how quickly prices move over a given time span. In the stock market, increased volatility is often a sign of fear and uncertainty among investors. This is why the VIX volatility index is sometimes called the "fear index." At the same time, volatility can create opportunities. Many of you often hear me say one of my favorite axioms: "It is not timing the market, it is time in the market". To me, over time many things are almost always certain... The cost, price, or value of just about everything will go up. They will fluctuate based on supply and demand. Cost of Goods will vary depending on many variables: Manufacturing, Construction, Transportation, Weather, Technology, Government rules and regulations, The Economy, The list can go on..., Those many variables may also affect the profitability and viability of a company, a community, or an organization.
I believe in Investing, over time, with consideration for risk and volatility that the results will be predictable and manageable. There are no guarantees in this world aside of my never ending love and respect for my family, my clients, colleagues, friends, God, and country. By managing and monitoring volatility and risk we can have the successful investment outcomes we are striving for.
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The definitions above are a compilation and editing from Investopedia words dictionary. The Opinions are my own. This Blog is not a solicitation to sell any specific product or investment. I always welcome any comment, questions, or suggestions,