Last Updated on May 24, 2022 by Aradhana Gotur
Volatility in investment parlance refers to the degree of fluctuation in the price of securities or assets. Volatility is often associated with risk as it may become difficult for an investor to ascertain a price point to sell the investment at a profit, should volatility be high. However, there are also advantages to volatility. It is an important concept, especially in the technical analysis of stocks. This article explores the concept of volatility and details what causes it and affects it. Read on.
Table of Contents
What is volatility?
Volatility is how fast the price of an investment fluctuates over time. It expresses the degree of risk associated with a security’s price fluctuations. Investors and traders analyse a security’s volatility to assess previous price changes and forecast future moves. Metrics of standard deviation or beta are the tools that are used to calculate volatility.
The standard deviation of a security’s price is a measure of its price dispersion. This statistic measures how much a stock’s price has deviated from the mean over a certain period. It is determined by subtracting the mean cost for the specified time from each price point. Squaring, adding, and averaging the differences yields the variance.
The volatility of securities or portfolios in comparison to the market as a whole is measured by beta.
The capital asset pricing model is a commonly used approach for pricing risky securities and producing estimates of projected returns on assets, taking asset risk and capital costs into account. This uses standard deviation or beta to characterise the connection between systemic risk and the returns anticipated from the asset (usually stocks).
The slope of a line made from a regression of data sets is known as a beta in statistics. In finance, each of these data points reflects the performance of a single stock relative to the market as a whole. The activity of a security’s returns as they respond to market fluctuations is adequately described by beta.
The beta of a security is determined by multiplying the product of the security’s covariance and the market’s gains by the variance of the market’s returns over a specific time. Investors use the beta calculation to determine if a stock moves in perfect sync with the rest of the market. It also tells you how unstable a stock is compared to the rest of the market.
A stock with low volatility has a generally steady price. A stock with a high amount of volatility is riskier. When you buy a volatile investment, you enhance your chances of success while also increasing failure risk (remember that the higher the risk, the higher is the potential for profits, and vice-versa). As a result, many traders with high-risk tolerance use several volatility indicators to assist them in planning their trades.
Types of volatility
Historical volatility
This indicator shows how the price of a security has fluctuated in the past. It is used to forecast future price changes based on historical patterns. It does not, however, provide information regarding the security’s price movement or direction in the future. This dispersion indicator is based on historical and empirical data; institutional investors often calculate it to strategise their moves.
Implied volatility
In contrast to historical volatility, implied volatility is a forecast of future changes in the value of securities. It is utilised by investors worldwide to forecast where a stock’s value will go without considering past data. In determining the pricing of options contracts, implied volatility is a crucial measure. Analysts believe in a variety of elements when forecasting future price changes in assets. Although it is presented in percentages, implied volatility does not indicate which way prices will go.
How to calculate volatility?
Calculating the standard deviation of a security’s prices over time is the most straightforward way to measure its volatility.
- Compile a list of the security’s closing prices for a chosen time frame.
- Determine the average (mean) price of the security’s previous close prices.
- Calculate the difference between each of the set’s prices and the average.
- The differences from the last step should be squared.
- Add the squared differences together.
- Divide the total number of prices in the collection by the squared differences (find variance).
- Calculate the square root of the number you just got.
Factors affecting volatility
Stock market volatility, like its counterparts, is influenced by a variety of variables. A few are listed below:
- Securities supply and demand
- Geopolitical variables
- Factors of socioeconomic status
- An options contract’s expiration date
Note that an unstable market does not automatically signal losses but maybe relatively risky. And experienced traders may utilise market volatility to their advantage by using their options contracts at the right time to earn significant gains or protect their portfolio from potential drawbacks.
Causes of price volatility
Three of the elements that affect pricing generate price volatility, as discussed above. Geopolitical instability, socioeconomic status and the expiration date lead to influence supply and demand. That apart, the below mentioned also cause price volatility.
Seasonality and Weather
The first is the concept of seasonality. Regular seasonal variations, such as seasonal changes in the price of seasonal fruits and vegetables, create volatility in demand and pricing in a few cases.
Sentiments
Sentiments are an aspect to be considered. Anxious traders increase the volatility of whatever they’re buying. That is why commodity prices fluctuate so much.
Summary
Volatility is an arithmetic measure of the spread of the returns from investment in an asset. It indicates how much an asset’s values fluctuate above or below the mean price. Beta coefficients, option pricing models, and standard deviations of returns are examples of techniques to quantify volatility. Since the price is less predictable, volatile assets are typically regarded as riskier than less volatile assets. Volatility is a significant factor in determining option prices.
