What is volatility and why does it matter

Stock markets around the world have recently experienced some very turbulent activity. The Dow Jones reached an all-time high of 26,616.71 points on the 26th Jan 2018 to then fall 10.4 per cent on Feb 8 2018. These large movements in the index sparked regular discussions about volatility in the market. So what does volatility actually mean and why is it examined in so much depth by market commentators?

What is volatility?

Volatility is the speed of a price changes of a stock. A stock with high volatility is one where the price changes rapidly over time, it will rise and fall at an accelerated rate. A stock with low volatility doesn’t fluctuate as frequently, the price change is at steady rate. The more volatile a stock is the more risky it is.

Volatility indicators

The market measures volatility with an indicator called the volatility index (VIX) which provides the level of optimism or fear in the market. The VIX is calculated from data from the Chicago Board Options Exchange (CBOE) from prices paid for puts and calls. If there is more call option buying (betting the market will move higher) than put option buying (betting the market will go down), then it reflects optimism. If there is more put option buying then it means the market is becoming fearful. The increased put buying will drive the VIX higher.  When the VIX is high, stock prices fall and traders look for safe havens like gold to invest in as it reflects investor fear. A low VIX conveys complacency.

The VIX index displays the volatility in the market but the volatility of a stock can be measured by the standard deviation. This represents the stock price movement compared to its average over time. A high standard deviation means a volatile stock and a low standard deviation means the stock does not move that much from its average.

Traders also use beta which measures the stock’s volatility in comparison to the market. A stock with a beta of 1 means the security moves in line with the market. A stock with a beta less than zero means it is less volatile than the market, stocks with beta of more than 1 means it more volatile than the market.

Why volatility matters?

Traders analyse the volatility index to determine the outlook of the investors in the market. Using this information, they can formulate strategies to profit from a falling market or identify possible reversals. The more volatile a market is, the bigger the price moves, which can provide greater opportunities to cash in profits. If there is less movement in the market, traders may need to wait longer before they see profits in their trades.

Volatility is also important as it is something to consider when assessing the performance of a stock. It represents how risky a stock is which needs to be considered for each risk profile. A high returning stock also means higher risk.

Day-traders welcome volatility as the large movements in stock prices present a chance to capture larger profits.

What causes volatility?

Interest rate changes can cause markets to react swiftly and become volatile. We discussed this in our previously article on how interest rate hikes negatively affects the stock market.

Inflation also impacts the volatility and we also discussed the sectors which benefit from high inflation.

How volatility affects the market?

  • Smaller stocks are generally more volatile than larger listed stocks
  • Sectors such as resources, IT and biotech tend to be more volatile than sectors such as health, telecommunications and industrials.
  • Newer companies are also more volatile than older established ones.
  • If volatility is high, options cheaper will be expensive, if volatility is low, option premiums will be cheaper.

Lauren Hua is a private client adviser at Fairmont Equities.

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