Volatility is a measure of how much an asset price has moved up or down. A more complete explanation of volatility is, you can read in the article below. Before that you can read other articles on the GIC website. You can also follow GIC's Instagram and YouTube to get more information and education about trading.

Understanding Volatility

Volatility is a measure of how much the price of an asset has moved up or down over time. Generally, the more volatile an asset is, the riskier it is considered to be as an investment and the greater the potential it offers for either higher returns or higher losses over a shorter period of time than an asset with relatively less volatility. In statistical terms, volatility is a measure of the standard deviation of the annualized returns of a market or security over a given period. Essentially the rate at which its price rises or falls. If the price fluctuates rapidly over a short period of time, hitting new highs and lows, it is said to have high volatility. If the price moves higher or lower more slowly, or remains relatively stable, it is said to have low volatility.

Types of Volatility

The following are types of volatility:

Price Volatility

Volatility is a measure of a key variable in option pricing models, estimating how much the underlying asset’s return will fluctuate between now and the option’s expiration. Volatility, as expressed as a percentage coefficient in option pricing formulas, arises from daily trading activity. How volatility is measured will affect the value of the coefficient used. Volatility is also useful in pricing option contracts using models such as the binomial tree or Black-Scholes model. A more volatile underlying asset will translate into higher option premiums because with volatility there is a greater chance that the option will expire in the money at expiration. Options traders attempt to predict the future volatility of an asset, so the price of an option in the market reflects its implied volatility.

Stock or Share Volatility

Investors have developed a measure of stock volatility called beta. This tells you how well a stock's price correlates with the Standard & Poor's 500 Index. If it moved perfectly with the index, the beta would be 1.0. A stock with a beta higher than 1.0 is more volatile than the S&P 500. A stock with a beta less than 1.0 is less volatile. Economists developed this measure because the prices of some stocks are very volatile. That uncertainty makes those stocks riskier investments. As a result, investors want a higher return because of the increased uncertainty.

Historical Volatility

Also referred to as statistical volatility, historical volatility (HV) measures the fluctuation of an underlying security by measuring the price change over a specified period of time. It is a less common metric than implied volatility because it is not forward-looking. When historical volatility increases, the price of the security will also move more than usual. At this point, there is an expectation that something will or has changed. If historical volatility decreases, on the other hand, it means that uncertainty has been removed, so things are back to normal. This calculation may be based on intraday changes, but often measures movement based on the change from one closing price to the next. Depending on the desired duration of the options trade, historical volatility can be measured in increments ranging from 10 to 180 trading days.

Implied Volatility

Implied volatility (IV), also known as projected volatility, is one of the most important metrics for options traders. As the name suggests, it allows them to determine how volatile the market will be going forward. The concept also gives traders a way to calculate probabilities. One important thing to note is that it should not be considered a science, so it does not provide a prediction of how the market will move in the future. Unlike historical volatility, implied volatility is derived from the price of the option itself and represents the expectation of volatility for the future. Because it is implied, traders cannot use past performance as an indicator of future performance. Instead, they must estimate the potential of the option in the market.

Market Volatility

Market volatility is the rate of price changes for any market. That includes commodities, forex, and the stock market. Increased stock market volatility is usually a sign that a market top or bottom is near. There is a lot of uncertainty. Bullish traders bid up prices on good news days, while bearish traders and short-sellers push prices down on bad news. The VIX® uses the prices of stock index options. The Chicago Board Options Exchange created it in 1993. It measures investor sentiment. The VIX® is also called the fear index. When the VIX® is high, stock prices fall. Often, oil prices also fall as investors worry that global growth will slow. Traders looking for safe havens bid up gold and Treasury notes. That sends interest rates down.

Causes of Volatility

Price volatility is caused by three factors that change prices. These factors work by changing supply and demand.

Political factors and economic policies

Governments play a major role in regulating industries and can impact the economy when they make decisions about trade agreements, legislation and policies. Everything from speeches to elections can elicit reactions among investors, which can affect stock prices. Economic data also plays a role, as investors tend to react positively when the economy is doing well. Monthly jobs reports, inflation data, consumer spending figures and quarterly GDP figures can all impact market performance. Conversely, if these miss market expectations, the market may become more volatile.

Industry factors

Certain events can cause volatility in an industry or sector. In the oil sector, for example, a major weather event in a major oil-producing region could cause oil prices to rise. As a result, the stock prices of companies involved in oil distribution could rise, as they are expected to benefit, while the prices of companies that have high oil costs in their business could fall. Similarly, more government regulation in a particular industry could cause stock prices to fall, as increased compliance and employee costs could impact future revenue growth.

Company performance

Volatility is not always market-wide and can be tied to individual companies. Positive news, such as a strong earnings report or a new product that wows consumers, can make investors feel good about the business. If many investors want to buy it, this increased demand can help the stock price rise sharply. Conversely, a product recall, data breach, or bad executive behavior can all hurt the stock price, as investors sell their shares. Depending on the size of the company, this positive or negative performance can also have a ripple effect on the broader market.

How to Calculate Volatility?

Volatility is often calculated using variance and standard deviation (standard deviation is the square root of variance). Since volatility describes changes over a period of time, you simply take the standard deviation and multiply it by the square root of the number of periods in question: vol = T where:
  • v = volatility over some time interval
  • = standard deviation of returns
  • T = number of periods in the time horizon

Sample case

Consider an investor who is building a retirement portfolio. Since he is retiring in the next few years, he is looking for stocks with low volatility and stable returns. He considers two companies:
  1. ABC Corp. has a beta coefficient of 0.78, which makes it slightly less volatile than the S&P 500 index.
  2. XYZ, Inc. has a beta coefficient of 1.45, making it much less volatile than the S&P 500 index.

More conservative investors may choose Acorporation for their portfolio, as it has less volatility and more predictable short-term value. That's all the explanation of the Volatility index. Also read other GIC articles, such as the explanation of Custodian Banks, only in the GIC Journal. Make sure to download and don't forget to register to be able to trade with GIC.