December 31, 2018

What is Volatility and How it Affects You?

What is Volatility and How it Affects You?

What is Volatility?

Financial market volatility is defined as the rate at which the price of an asset rises, or falls, given a particular set of returns. It is often measured by looking at the standard deviation of annual returns over a set period of time.

At its core, volatility is a measure of how risky a particular investment is, and it is used in the pricing of assets to gauge fluctuations in returns. That is, when the volatility is high, the trading risks are higher and vice versa. When volatility is used in the pricing of financial assets, it can help to estimate fluctuations that are likely to occur over the short term.

If an asset’s price fluctuates quickly within a short timeframe, then it is considered highly volatile. An asset whose price moves slower over a longer time period is said to have low volatility.

Types of Volatility

Volatility is one of the factors that investors in the financial markets analyse when making trading decisions. There are two key approaches to volatility, each with its pros and cons:

  • Implied Volatility: The term implied volatility describes the estimated volatility of an asset and it is a common feature of options trading. Implied volatility reflects how the marketplace views where volatility should be in the future, but it does not forecast the direction that the asset’s price will move. Generally, an asset’s implied volatility rises in a bear market because most investors predict that its price will continue to drop over time. It decreases in a bull market since traders believe that the price is bound to rise over time. This is down to the common belief that bear markets are inherently riskier compared to bullish markets. Implied Volatility is one of the measures that traders use to estimate future fluctuations of an asset price on the basis of several predictive factors.
  • Realised / Historical Volatility: Realised volatility, also known as historical volatility, is a way of statistically measuring how the returns from a particular asset or market index are dispersed when analysed over a given timeframe. Normally, historical volatility is measured by establishing the average deviation of a financial instrument from its average price over a given period of time. Standard deviation tends to be the most common measure of realised volatility, though there are other methods used to calculate this metric. Risky security is one that has a high historical volatility value though, in certain types of trades, it is not necessarily a negative factor since both bullish and bearish conditions could be risky.

In relation to these two metrics, historical volatility (backward looking) serves as a baseline measure, with implied volatility (forward-looking) defining the relative values of asset prices.

If the two metrics show similar values, then an asset is considered to be fairly priced on the basis of historical norms. For this reason, traders look for deviations from this equilibrium to establish if assets are overvalued or undervalued.

The Standard Deviation Model of Assessing Financial Volatility

Standard deviation is a measure used to statistically determine the level of dispersion or variability around the average price of a financial asset, making it a suitable way to measure market volatility.

In general terms, dispersion is the differential between an asset’s average value and its actual value. The higher the dispersion or variability, the higher the standard deviation is. The lower the variation is, the lower the standard deviation. Analysts often use standard deviation as a means of measuring expected risk and determining how significant a price movement is.

How Market Volatility Affects Trader Sentiment

Analysing market sentiment is an essential part of financial data analysis. Prices of assets traded on the financial markets will usually move up and down on a daily basis – a natural effect of the stochastic behaviour of the financial market.

In spite of these price movements, hundreds of millions of investors worldwide continue to risk their money in the financial market, hoping to make returns in the future. The volatility of the financial markets is of interest to investors since high levels of volatility often come with the chance of huge profits or significant losses at the expense of higher uncertainty.

If volatility is extremely high, investors may choose to stay away from the markets in fear of losing their funds. Others might engage in riskier trading in the hope of earning higher profits.

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Derivatives Based On volatility

Besides investments in stocks, currencies or commodities, some traders opt to invest in the concept of volatility itself through a number of derivative investments. These include exchange-traded notes (ETNs), which are similar to ETFs (exchange-traded funds) but are actually unsecured debt notes.

One of these derivatives is VIX, the ticker symbol for the Chicago Board Options Exchange Market Volatility Index. This index serves as a measure of how much traders are willing to invest in buying or selling of the S&P 500 index options.

The VIX is often referred to as the fear index or the fear gauge. The biggest and most popular VIX-related investments are the iPath S&P 500 VIX Short-Term Futures ETN (VXX) which has long positions in futures contracts.

If you would want to trade on financial market volatility or use it as a hedge, then the VIX-related ETNs are acceptable instruments.

The Final Word

Although some people have a negative view of volatility within the financial markets, it can actually increase the potential for profit if short-term trades are correctly predicted.

Cryptocurrencies, such as Bitcoin, are extremely volatile, but this is exactly what made trading them so profitable over the last few years. Once you understand volatility and how it impacts asset prices, you are then able to benefit from these price movements.