The Concept of Volatility Explained

July 27, 2023
10 MIN READ
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Volatility indicates the size of the value of an asset that fluctuates around the mean price; it is an indicator of statistics of its return dispersion. Volatility may be measured using various methods involving option pricing models, beta coefficients, and standard deviations of returns. Volatile investments are frequently seen as more volatile than more stable assets since their prices are less predictable. Historical volatility monitors price fluctuations over preset time periods, whereas implied volatility estimates the market's volatility. Volatility is a significant element in the determination of option pricing.

What is volatility?

Volatility is an empirical indicator of the spread of an asset's or market index's returns. The more volatility, in most situations, the riskier the asset. Volatility is sometimes assessed by the standard deviation or variation of outcomes from the same securities or market indicator.

Volatility in the financial markets is frequently linked with significant shifts in either direction. A volatile market, for instance, is one in which the equity market increases or decreases by over one percent over a continuous period. The volatility of an asset is an important consideration when pricing options transactions.

The concept of volatility

Volatility is frequently used to describe the degree of risk or unpredictability associated with the magnitude of variations in the value of an investment. Higher volatility indicates that an investment's value might be distributed over a wider range of values. This implies that the security's price might vary drastically in either way in a short period. Lower volatility indicates that the value of an asset does not vary substantially and is more stable.

One technique to assess an asset's fluctuation is calculating its daily returns (percentage change daily). Past volatility is calculated using past prices and indicates the degree of fluctuation in an asset's returns. This value is given as a percentage and does not have a unit.

While variance generally represents the distribution of returns around a stock's mean, volatility is an expression of that variance over a given time frame. As a result, we may report volatility daily, weekly, monthly, or annual. Volatility may thus be thought of as the yearly standard deviation.

Formula of volatility

The variance and standard deviation are commonly used for estimating volatility (the standard deviation is the square root of the variance). Because volatility indicates variations over a particular time frame, increase the standard deviation by the square root of a certain number of intervals in question:

Vol = σ √T

Where:

·        v = volatility over some interval of time

·        σ =standard deviation of returns

·        T = number of intervals in the time horizon

Stock price volatility is assumed to be mean-reverting, which means that times of high volatility frequently lessen and instances of low volatility increase, swinging about some long-term mean.

Calculation of volatility

Calculating the standard deviation of an asset's prices over time is the easiest way to measure its volatility. This may be accomplished by following the steps below:

·       Compile the security's previous prices.

·       Compute the average (mean) price of the stock's previous prices.

·       Calculate the difference between each set's prices and the average price.

·       Differences from the previous step should be squared.

·       Add the squared differences together.

·       Find the variance by dividing the squared differences by the total prices in the collection.

·       Compute the square root of the number you got in the previous step.

Classifications of volatility

     i. Projected volatility

One of the essential measures for options traders is projected volatility, implied volatility (IV). As the name implies, it enables them to forecast the stability of the market will be in the future. This idea also allows traders to compute likelihood. One crucial factor to remember is that it is not science; thus, it cannot predict how the market will move.

In contrast to historical volatility, projected volatility is derived from an option's price and shows volatility predictions for the future. Traders cannot use previous performance as a sign of future performance since it is implied. Instead, they must assess the market viability of the option. Options trading relies heavily on implied volatility.

     ii. Statistical volatility

Statistical volatility, also known as historical volatility (HV), measures price movements across predefined periods to analyze the variations of underlying assets. Since it is not forward-looking, it is less common than implied volatility.

When statistical volatility rises, the price of a stock moves more than usual. There is an anticipation that an attribute will or has shifted. If statistical volatility falls, it suggests that ambiguity has been erased and things have returned to normal.

This computation may be following intraday shifts, although it is most commonly used to quantify movements from one the final cost to the subsequent. Statistical volatility can be calculated in intervals ranging from 10 to 180 trading days, contingent upon the length of the options contract.

The relationship between volatility and option pricing

Volatility is essential in options pricing schemes, indicating how much the fundamental stock's return will change between the present and the option's maturity. Volatility occurs from everyday actions and is quantified as a proportion coefficient in option-pricing formulae. The coefficient's value is affected by how volatility is calculated.

Volatility is also employed in option pricing models such as Black-Scholes and binomial tree algorithms. More unstable fundamental assets will result in higher option charges since there is a larger likelihood that the options may expire in the money. Options investors attempt to forecast an asset's future stability; therefore, the market price of an option indicates its implied volatility. The higher the volatility, the greater the stock market price of options agreements overally

Other volatility metrics

·       The VIX index

The volatility index (VIX), a numerical indicator of broad market swings, can also gauge market volatility. The Chicago Board of Options Exchange developed the VIX as a metric to evaluate the 30-day projected unpredictability of the US financial sector based on real-time quotation prices of S& P 500 call and put options.1 It measures future bets made by investors and traders on the magnitude of the markets or particular assets. A high VIX rating indicates an unstable market. Investors can transact the VIX with various options and exchange-traded products or utilize VIX values to price specific derivative products.

·       Beta

An asset's beta (β) is one indicator of its relative volatility to the economy. A beta estimates the general volatility of a stock's returns compared to the returns of an appropriate reference (often the S& P 500). For instance, a security with a beta of 1.1 has typically fluctuated 110% for every 100% change in the standard, depending on its current price. A share with a beta of.9, on the other hand, has typically surged 90% on each 100% change in the set standard.

The relevance of volatility to traders

Volatility is important to investors for a minimum of eight factors:

·       Volatility impacts option pricing and is an element of the Black-Scholes concept.

·       When you retire, your return volatility is higher. Thus withdrawals have a greater long-term influence on the value of your portfolio.

·       Price volatility provides opportunities to acquire assets at a discount and sell them when they are expensive.

·       Portfolio volatility reduces a given investment's compound annual growth rate (CAGR).

·       The greater the price swings in an investment, the more difficult it is to remain emotionally calm.

·       The volatility of a financial instrument's price can be used to determine position size in a portfolio.

·       When particular cash flows from the sale of a security are required at a specified future date, increased volatility increases the likelihood of a shortage.

·       When investing for retirement, more volatility of returns leads to a broader distribution of possible ultimate portfolio values.   

The management of volatility

High volatility may upset investors since values might fluctuate dramatically or crash quickly. Long-term investors would be wise to overlook short-term volatility and maintain the course. This is because equity markets tend to grow in the long run. However, emotions such as fear and greed can be heightened in volatile markets, undermining your long-term approach. Some financiers can also exploit volatility to add to their holdings by purchasing dips when prices are very low. To handle volatility, you can also utilize hedging tactics such as buying protective options to minimize negative risks without liquidating your stocks. However, put options will become more expensive as volatility rises.

The following are the detailed steps to consider when taking advantage of the market volatility:

     i.     Establish goals and fortify safety measures.

Before attempting to trade turbulent markets, it is critical to be emotionally and strategically ready to handle the dangers.

Position size and stop-loss placement are two critical factors to consider. When markets are volatile, some traders conduct smaller deals (commit less capital to each trade) and utilize a broader stop-loss than when markets are tranquil. The aim is to avoid being stopped owing to wider-than-normal daily price volatility while striving to maintain the same total risk exposure.

     ii.     Concentrate on equities that are moving with the market.

One important potential in trading tumultuous markets is that trending equities can view their trend accelerate. This implies that seeking equities already going in the general market may allow a trader to produce gains more rapidly than during regular, quieter markets but at a possibly higher level of risk, as previously indicated.

     iii.     Monitor the emergence of consolidation breakouts.

An investor uses this method to track a stock transacting inside a definable resistance and support band. No action is performed so long as the shares remain inside the specified range. If, on the other hand, the price infringes the upper limit, the investor will attempt to purchase the stock right away, hoping that the breakout marks the start of a new up leg for the company.

In calmer markets, an asset may break through to the upside and lose traction, drifting sideways or moving below the breakout limit. In a turbulent market, where prices move quickly, an upward breakout might be followed by an instant and significant surge to elevated prices. This perspective is the key incentive for trading breakouts in a volatile market.

The caveat is that an alteration from an inaccurate breakout can occur rapidly in a turbulent market, and the resulting price loss could be worse than in a calmer market. As an outcome, in a turbulent market, an investor who chooses to purchase the breakout ought to seriously contemplate using a stop-loss order to possibly restrict their loss once the price drops a set level below the breakout limit.

     iv.     Explore short-term approaches.

When markets are unstable, investors may also employ a shorter-term trading approach. This usually entails seeking to collect profits or, at the very least, lock in profits more swiftly than usual.

Within increasingly unstable markets, where profits might evaporate and change into deficits rapidly, one may want to consider the following changes to quit the transaction more quickly:

·       Set a certain profit % objective.

·       Sell a portion of a stock at the first suitable profit-taking opportunity and keep the remainder in the expectation of making more profits.

·       Employ an overvalued/oversold indicator (such as RSI) and transact when it indicates that the stock is overvalued.

·       Apply a tighter leading stop and initiate a trailing stop earlier than usual.

Is risk similar to volatility?

Volatility is frequently used to characterize risk; however, this is not always the case. Risk refers to the possibility of suffering a loss, whereas volatility refers to how large and fast prices change. The risk rises if such larger price swings also raise the possibility of losses.

Is volatility beneficial?

Volatility may be beneficial or detrimental depending on the type of dealer you are and your risk tolerance. Volatility might be problematic for long-term traders. However, for short-term and options traders, volatility typically means trading prospects.

What does higher volatility indicate?

When volatility is elevated, it signifies that prices fluctuate rapidly and sharply (both rising and falling).

Conclusion

Volatility refers to the amount and how rapidly prices change over a certain period. High volatility in the shares market frequently indicates investor concern and uncertainty. As a result, the volatility index is also referred to as the "fear index." Simultaneously, volatility provides chances for day trading to enter and leave holdings. It is also an important factor in the pricing of options and marketing.