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Volatility is a measure of risk that is the statistical quantification of a security's possible investment returns. In short, it means large swings in price over a short period of time.
Volatility in the securities markets means large swings in price over a short period of time. Technically, volatility is the statistical measure of the security’s possible investment returns. In simpler terms, it is the degree of variation in its trading price over time. If a security has large price swings over short time periods it’s volatile and unpredictable. This erratic behavior is a sign of high risk.
High-risk securities usually have high volatility. If the fluctuation is smaller over a longer period of time, the volatility is low. These measurements are done using a standard deviation of returns, option pricing models, or beta coefficients. Volatility is a significant factor for calculating the prices of options. It is essential to note that volatility does not measure the direction of the swing, but the size of the deviation.
What are the different types of volatility?
There are two basic types of volatility: implied and historical. Implied volatility is based on projections, while historical volatility is based on historical data.
Implied volatility is a valuable measure for traders
Implied volatility is based only on an option's price and projected performance. There may be no historical data available, so an estimate of the potential is made based on the information at hand. With implied volatility, you are not predicting if the price of the security will move up or down; you are simply predicting how volatile it will be in the market. Most often, traders use option pricing models to determine implied volatility. Once you understand how to read the implied volatility of a security, it helps you decide its future value and when to trade.
There are a couple of ways to determine implied volatility. One is the Black–Scholes Model, which takes into consideration current market pricing, time to expiration and interest rates. Another method is the binomial model, which uses a formula to help determine the direction a price is heading. There are also online implied volatility calculators available that help simplify the process even further.
Some models break down implied volatility even further. Within the implied definition, calculations may be using historical prices of the options, referred to as historical implied volatility. Current implied volatility refers to observations made from current pricing, and future implied volatility, of course, refers to the future prices of the option.
It is critical to know that implied volatility is not scientific. It is based on projections and should be used as a guide rather than a forecast of future performance.
Historical volatility measures changes in prices over time
Historical volatility, also referred to as statistical volatility, is different from implied volatility because it isn't predicting activity or pricing changes by looking forward. Rather, it is using historical data and basing predictions on what has happened in the past. Historical volatility is generally expressed as a percentage that reflects the deviation from the average price. Pricing that fluctuates during a defined period is deemed more volatile or less stable.
Historical volatility uses the standard deviation of the log of the ratio of consecutive market closings over a defined period of time. Closing prices are tracked to determine the volatility or swings in a security or option. The fewer the changes, the more stable the security. Many traders use a combination of implied volatility and historical volatility to guide their decisions and analyze trading. Calculating historical volatility can be tedious and time-consuming, not unlike implied volatility. To get more information on historical volatility you can get help from brokerages — which often have already done the calculations for you.
What is the VIX?
The Chicago Board Options Exchange created the CBOE Volatility Index, known as the VIX, as a way of drilling down further into the performance and volatility of S&P 500 Index options. Sometimes known as the “fear gauge,” the VIX Index measures the level of implied volatility of the S&P 500 Index over the next 30 days. This weighted mix of the prices of S&P 500 index options measures how much people are willing to pay to buy or sell the S&P 500. When they are willing to pay a higher price it means more uncertainty.
When volatility is low, the VIX is low and when the market is more volatile, lifting the “fear” factor, the VIX is high. Investors plan to buy when the VIX is high and sell when it is low, but there are always other factors that they use to determine buy/sell tactics.
What causes volatility?
Market volatility can be caused by many things, some seemingly unrelated to securities, such as economic or policy factors, interest rate hikes, political instability, war and the Federal Reserve’s monetary policy. Since volatility is a measurement of uncertainty or fear, it is easy to understand why. So, although volatility develops for many reasons, it is important to note that even as little as a 1% deviation in the market can get it the label of volatile.
Politics can cause volatility
Of course, when there is a change in government, it leaves investors with uncertainty. How will the new players affect financial policies? What changes in legislation could prompt changes in trading? Even if there are no elections or new officials, there could be changes in foreign or domestic policies that could leave investors unsure of what is to come and how they will be affected. A declaration of war between two countries, even if your own country is not involved, could affect trade and pricing (consider Russia and Ukraine).
Some economic factors are also tied to politics and government. When the Federal Reserve raises interest rates, the increased cost of borrowing may raise volatility in the market. Investors may sell in order to take advantage of higher interest rates offered by banks, causing negative changes in the market. Changes to tax laws, reports on unemployment and inflation, and announcements concerning customer spending can all increase volatility.
Volatility is not affected only by trade agreements, legislation, or elections. Rumors, illnesses and even speeches can cause stocks to plummet or soar, setting the market on its ear.
Industry news can affect market volatility
Storms that damage oil production, wars that diminish the import or export of consumer goods, or a major industry leader involved in legal issues can influence not only the volatility of the options directly related to that industry but also other industries as well, sending the volatility numbers soaring.
Think of it this way: Oil wells were damaged by a storm; gas prices go up. Industries that rely on oil production, either for fuel or petroleum products, pay more; as well as trucks that haul consumer goods. Therefore, the cost of goods increases. The disruption to the oil wells affects multiple industries, thus making the market more volatile than ever.
When new laws are put in place to regulate any particular industry, they can affect the market’s volatility. Similar to the example of the damaged oil wells, if new legislation is passed to regulate an industry or a market segment, the results are usually far-reaching and affect more than the targeted business segment.
It doesn't have to be legislation. Sometimes volatility is created by a rumor. Since volatility is worsened by uncertainty and fear, a rumor could leave investors unsure of the future and more likely to protect themselves and their money.
Company performance can drive volatility
A company facing litigation or a serious recall could see their stock trade with more volatility. Prices could fall off sharply and would be considered a risky investment. But it doesn't always have to be negative. A company that creates a successful cancer drug, making an available and affordable product, may send the price higher, also making it more volatile.
There will always be fluctuation in the market
Markets will always experience some fluctuation. That fluctuation is normal. However, if it is sustained over a long period of time or if the fluctuation is sharp and indicates future changes, then the fluctuation crosses the line into volatility.
Risk vs. volatility
You may think that risk and volatility are the same and that you can use the terms interchangeably, but this is not the case. When you invest in an option with high volatility, you may be taking a risk. Conversely, making a risky investment doesn’t always mean investing in a highly volatile security or option.
Volatility predicts future pricing by using objective data. You may use volatility information to mitigate risk when investing, but volatility may result in either losses or gains. Risk, however, denotes a negative prediction of loss and tends to be more subjective. Most often, risk is the possibility of failure. Although riskier investments yield greater returns when successful, they also offer greater opportunity for losses and the possibility of losing your entire investment.
In investing, you can minimize risk and look forward in order to determine feasibility. You cannot, however, minimize volatility that is based on historical performance and data.
Can volatility be managed?
Volatility can assess risk, offering guidance to investors. It is not always a negative phenomenon since it also creates opportunities for the investor. Keep in mind that volatility is based as much on perception as on value. This can be advantageous when you understand the options you are dealing with.
There is probably one word that best describes the management of volatility: patience. Sometimes, during times of high volatility, it is best to just hold on and ride it out. Jumping in and out of the market will ultimately end up in more losses than if you just held on for a short while longer. Remembering that short-term investments seldom yield long-term profits will help you manage your portfolio and create the optimal result.
How can investors use volatility to their advantage?
As an investor, you can use volatility to your advantage by incorporating it into your trading strategies. All investments carry risk. By watching and identifying stocks when they are low and doing your due diligence in tracking the volatility, you can trade for a profit. Even though the stocks with the highest volatility tend to be more emotional investments, smart investors can weigh their portfolios to include lower-risk options in the desired proportion to those with higher volatility.
Investors should also look at the length of time they are willing to invest and consider whether their investments are pigeonholed for a particular event or purpose, such as retirement or a vacation home. The amount of time and money that you are willing to invest could directly correlate with the volatility of your securities.
High volatility vs. low volatility
Which is better, high volatility, or low? Once again, this goes back to the length of time you plan on investing and the amount of risk you are willing to take. If you are in it for the long haul and you don't plan on pulling your money out any time soon, consider investing the majority of your funds into low-volatility options. If your portfolio is to fund your retirement, you may be better off investing in proven securities with low volatility. Your profit will be less but your investment will be safer. If you still want to gamble a bit, invest the majority of your money into low-volatility investments and choose one or two with higher volatility.
If you are not afraid of some risk and you can afford a loss, higher volatility is an option. Sure, you put more on the line, but the rewards are greater as well. Younger investors seem to be more comfortable with high-volatility stocks since they have more time to rebound if their investments are not as profitable as anticipated.
Most financial advisors recommend diversifying when investing. Invest in stocks, bonds or other securities, spreading your investments between different types of companies in different industries with different volatility ranges. This helps to protect your investment as you continue to increase your portfolio.
Volatility key takeaways
Volatility is the ups and downs in the market, the swings in price that influence the ways that people invest. It can be calculated historically, with data available from prices over a given time period, or it can be predicted (implied) based on calculations formulated to determine future pricing and performance.
Market volatility is often affected by industry changes, political happenings, or a company's performance and can change on a dime due to common occurrences that happen globally. The best way to manage volatility while investing is to be alert, informed and patient. Volatility can be used to an investor's advantage by creating optimal buy-sell windows and by diversifying their portfolios.