What is volatility? Volatility is a broad term, used loosely by many in the financial world. Sometimes it relates to price movements, while at other times, it is synonymous with risk. This article explores in depth what volatility is, various types of volatility, how a trader or investor might take volatility into account when forming their strategies, how volatility could be used in an attempt to generate profit and more. At the end of this article, you will also find answers to frequently asked questions about volatility.
Table of Contents
What is Stock Market Volatility?
Volatility is a general term, used to describe many different types of movements in price, or more precisely, a range in which the price of an asset moves. In general, it refers to how much a certain asset’s price shifts over a period of time, serving as an indicator of its stability and risk. Usually, the higher an asset’s volatility, the riskier it is considered. However, risk is also impacted by other factors.
Volatility may be generated by factors such as unexpected weather conditions, interest rate decisions, geopolitical factors, earnings reports, and numerous other reasons. That is a main reason investors are usually very keen to read any news about a company or asset in which they invest. However, while these can cause sudden price changes, they are not what makes an asset volatile. To be considered an asset of high volatility, it has to display a broad movement in prices over a long period of time.
Volatility Types Explained
There are various types of volatility and different ways to categorize them. Sometimes, volatility types are explained in relation to a certain asset. Another way could be to explain volatility in relation to a certain market or a specific benchmark, such as the S&P 500 index. Here are some common types of volatility:
- Price volatility — This refers to the volatility of a specific asset’s price over a period of time. Often, to calculate the risk involved with the asset, analysts use the average range of prices over a period of time and display it as a percentage of the asset’s price. For example, an asset that has average volatility of 5% is considered more volatile than one that has average volatility of 1%.
- Stock volatility — This refers to the volatility of a certain stock, as compared to a known benchmark. The asset’s average volatility is compared to that of a popular index, such as the S&P 500, producing a score known as a beta. If the score is 1, it means that the stock’s volatility is identical to that of the benchmark. If it is higher than 1, the asset is more volatile. If it is lower, it is less volatile.
- Historical volatility — As the title suggests, this type of volatility refers to the past performance of a certain asset. While past performance is never an indicator of future results, knowing an asset’s history of volatility can serve as a factor in gauging its stability, and risk, in both the short and long term.
- Implied volatility — This type of volatility is calculated using the actions of options traders, meaning it is based on sentiment and speculation. By seeing how these investors believe a certain asset will behave in the future, it is possible to conclude the overall volatility they believe the asset will display.
- Market volatility — As opposed to price volatility, this kind of volatility relates to the market as a whole. For example, the VIX index is based on the aforementioned implied volatility, but instead of relating to one specific asset, it gauges the volatility of the Wall Street stock market in its entirety.
Market volatility in the Short, Medium and Long Term
Ways for managing volatility
Volatility in 2020
The 2020 global coronavirus pandemic had numerous periods of high volatility, such as travel stock prices crashing when countries closed their borders, or markets soaring when economies began to reopen.
Using the beta metric explained above, it is easy to track the most volatile stocks in the first half of 2020.
Stock Volatility, H1 2020
|BLUE APRON HOLDINGS INC-A||-3.47771|
|RESTAURANT GROUP PLC||3.255767|
|CINEWORLD GROUP PLC||3.140366|
|SPIRIT AIRLINES INC||3.09679|
|TILRAY INC-CLASS 2 COMMON||3.053074|
|AVIS BUDGET GROUP INC||3.014662|
|TENET HEALTHCARE CORP||2.897564|
|LINCOLN NATIONAL CORP||2.798159|
|ROYAL CARIBBEAN CRUISES LTD||2.792185|
|HERTZ GLOBAL HOLDINGS INC||2.790192|
Data is accurate as of 10/6/2020
The Beta column refers to the average movement of the stock as compared to a major index. For example, Blue Apron, a popular meal kit delivery service, was more than three times less volatile than the S&P 500 index, meaning it was more stable during the coronavirus pandemic, most likely due to the fact that it was in steady demand.
In contrast, the travel sector became extremely volatile, as it was incredibly susceptible to the constant changes in travel restrictions, lockdowns and reopenings. This is apparent from the figures above, showing that car rental giants Avis and Hertz, alongside travel and leisure companies Spirit and Royal Caribbean were 2.7-3 times more volatile than the benchmark index.
Can Volatility be Predicted or Tracked?
As the segment above suggested, there are various ways to track and predict volatility. While tracking can be done to precision, predicting volatility is not an exact science. If it were, the lives of financial analysts and investors would be much easier.
One of the most common metrics used for tracking volatility is the Average True Range (ATR). Determining an asset’s ATR is done by calculating its price range each day over the course of a certain period, and then finding the average range. However, since different assets have vastly different prices, the resulting dollar value is then converted into the percentage of the asset’s price, resulting in a common factor that can be used for comparing different assets’ volatility.
Naturally, predicting volatility is not a pure mathematical process, since it involves trying to determine an asset’s future movements. To try and predict it as accurately as possible, analysts use real-time quote prices of S&P 500 call and put options. Essentially, they gather a large number of “bets” placed by traders, who believe an asset will rise or fall a certain amount, and use this information to generate an image of where said traders believe the market is heading. The result is a fairly accurate estimate of where the market is believed to be heading. However, it cannot serve as a guarantee.
What can Volatility Mean for Traders?
For short-term traders, volatility is their lifeblood. Quick and erratic price movements serve as the best breeding ground for quick profits — providing they can predict the direction in which the price will move. Therefore, many short-term traders eagerly await any and all factors that can generate volatility. Government reports, central bank press conferences and breaking news stories are just some of the factors that can generate volatility, and traders are always on the hunt for such opportunities.
However, one person’s opportunity is another person’s risk. Long-term investors equate volatility with risk — and with good reason. If you are investing for the long term, the ideal situation is to have a steady incline with a minimum drawdown. Therefore, in theory, the less volatile an asset, the less likely it is to show a sudden drop in price.
Therefore, volatility should be factored in when determining a trading or investment strategy. If the aim is for steady, low-risk growth, it is better to look for assets which are less volatile. However, for those with a higher risk appetite who are looking for short-term results, high volatility may be more suitable.
Is it Possible to Profit from Volatility?
The short answer is “yes.” There are various ways in which one can profit from volatility. However, these also come with a risk factor. Higher volatility means larger price movements, which, in turn, could be translated into profit, assuming the trader picks the right direction for the trade. If they don’t, they run the risk of losing larger sums than they would with a less volatile asset.
Short-term traders can definitely use volatility to their advantage, but should also consider that volatility is innately a form of instability. Therefore, those who use a more technical approach, may want to avoid assets that are too volatile, as they are more likely to stray away from standard models.
In addition, some traders utilise various levels of leverage, further expanding their exposure to volatile assets. While this can serve as a means of obtaining more profit, it is a double-edged sword, since losses are also leveraged and if the volatile asset suddenly shifts into the opposite direction to the trader’s investment, it will lead to rapid losses.
Volatility: Frequently Asked Questions
Below you will find some questions and answers relating to the topic of volatility:
Is there a way to track market volatility?
Yes there is. While some analysts conduct their own research and do their own calculations, others rely on ready-made instruments. For example, the popular VIX index, also known as the “fear index,” measures the volatility of Wall Street, and is considered a reliable indicator of market volatility and overall investor sentiment.
Are some asset classes more volatile than others?
Yes. For example, currencies are usually not very volatile, often moving within a decimal spectrum throughout the course of a day. This is the reason currency traders often utilise significant leverage. Cryptocurrencies, on the other hand, are known to be much more volatile, sometimes showing double-digit price swings over short periods of time.
How does volatility affect technical analysis?
While often generated due to fundamental factors, volatility is definitely factored in by technical analysts. Some assets are highly volatile all the time, meaning their volatility is taken into account when using technical analysis models to try and determine where they will go next.
Are volatility and risk the same thing?
No. Volatility has to do with the range in which an asset can move, while risk has to do with its potential to suddenly change direction. In theory, an asset can be very volatile, but display predictable patterns over time, which actually makes it less risky. Often, volatility is considered a reliable measure of an asset’s risk, however, there are other factors that need to be taken into account when determining risk levels.
Should long-term investors fear volatility?
There’s no one answer here. Volatility is indicative of risk, but it is also quite common in emerging markets and highly innovative fields. Sometimes, high volatility is taken into account during the earlier stages of a certain market’s development. Therefore, it is quite possible that a long-term investor invests in a volatile asset, while believing that it will become less volatile over time.
Managing volatility on eToro
On the eToro platform, there are many ways to track volatility and manage risk when investing in stocks. Here are some ways this can be done:
- Use ProCharts — eToro’s ProCharts offer traders and investors a variety of tools to track assets, compare different instruments, and apply analysis tools, such as ATR.
- CopyTrader™ — On eToro, you can allocate some of your funds to replicate the actions of another trader. Each trader on the platform has a unique risk score, ranging from 1 (very low risk) to 10 (extremely high risk). Traders with a lower risk score will most likely be more inclined to invest responsibly, and therefore, are less prone to volatility.
- Use the Research tab — many stock pages on eToro have a dedicated tab full of useful information, such as market sentiment and analyst consensus. With this tab, you can easily see what professional analysts are saying and examine how they feel regarding a certain stock.
If you think that you are ready to start investing on your own, feel free to try eToro. When you sign up, you will receive a free demo account with $100,000 of virtual money with which to experiment, so you can try out the platform before making your first deposit.
Sign up to eToro to practice your risk management skills.
This information is for educational purposes only and should not be taken as investment advice, personal recommendation, or an offer of, or solicitation to, buy or sell any financial instruments. This material has been prepared without regard to any particular investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past performance of a financial instrument, index or a packaged investment product are not, and should not be taken as a reliable indicator of future results. eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this guide. Make sure you understand the risks involved in trading before committing any capital. Never risk more than you are prepared to lose.