What is Volatility?

 

 

In this video by HDFC Mutual Fund, let’s learn about volatility and how to invest in shares or mutual funds when you are experiencing market lows. If you need further assistance, reach out to us in the comments section below. 

 

Volatility is the up and down market movement. Let us assume a stock to be at one price, but it drastically goes up or down over a short period. Such activities reflecting volatility are calculated as the standard deviation from the expectation. If a position goes through remarkable changes in value, we call this position highly volatile. However, low volatility means the position is stable. High volatility brings uncertainty and can generate much profit if a person is willing to take the risk. 

 

Volatility in the Stock Market

 

Volatility exists in each stock to a different degree in the stock market. Indexes represent a basket of stocks; hence, their volatility is derived from the relation between the volatilities of individual stocks.

 

The current volatility of a stock can be gathered from the volatility index indicator available in the charting tools of any virtual trading platform. 

 

There are superseding trends that prevail in the stock market, impacting the stock market’s volatility. These trends are set off by national or global events. Some of these events are the Lehman Brothers crisis, the US Housing industry collapse, the Dot-com bubble burst, etc. These events have increased uncertainty in the stock market regarding returns and prospects of industries and economies. 

 

 

Different Measures of Volatility

 

Reasons why you should measure volatility:

 

• Use it to make profitable trades

 

If you understand the stock market volatility you can use it to make profitable trades in the derivatives market. Stock derivatives like options are financial instruments that have a very specific factor of stock volatility to determine its price. If you can measure and predict the volatility, you can use that information to make profitable calls regarding the option price.

 

• To gather an understanding of the economic stability in the market

 

Volatility is a direct resemblance of the anxiety levels and anxiousness of the investors. These levels increase on two accounts. Suppose the average stock market investors are anxious and uncertain about returns in the stock market. In such a case, the volatility increases. Even if the investors are excited and optimistic about the stock market’s prospects, the increase in trades and volumes escalates the volatility. Increased Volatility directly impacts the economic stability of a market.

 

• To adjust stop loss in a trade

 

By having a stronghold on the volatility levels of the stock market, you can adequately understand the appropriate levels of stop-loss without falling into the traps of false trend reversals.

 

How to measure the volatility of stocks:

 

• ADX – Average Directional Index 

 

It is a measure of the volatility of the stock in a qualitative aspect. The scale of ADX ranges from zero to a hundred, where zero indicates no unexpected or unsystematic changes in the stock price; however, any value greater than 30-40 suggests a strong trend is about to prevail. The direction of the movement (opposite or same) with respect to the previous trend is uncertain. 

 

•  ATR – Average True Range

 

It is a technical indicator based on the volatility of the underlying stock. ATR considers the levels of gap openings while measuring the stock volatility by adjusting it to the daily price movement range. It can also give you a sense of how strong price moves are, which is helpful if you are trying to identify the start of a trend. ATR is measured in an absolute value directly proportional to the magnitude of movements in a given time.

 

• Bollinger Bands

 

Bollinger bands combine two lines above and below the price line, forming a price line band. The width of the band is a measure of 2-standard deviation above and below the price line. The standard deviation is calculated over a fixed period. The bands act as extremes of price movements, and signal traders of volatility increase.

 

 

What are the Types of Volatility?

 

• Historical Volatility

 

Historical volatility is the measure of volatility experienced by the stock or stock market in a fixed period. This type of volatility is a lagging indicator and helps in only interpreting past data and explaining the effects of volatility movements. 

 

It is calculated based on the standard deviation of a fixed period on a rolling basis to maintain continuity. The significance of historical volatility lies in the fact that past movements impact future movements and are also bound to repeat themselves.

 

• Implied Volatility

 

Implied volatility (IV) can measure the expected volatility in the future. Numerous factors and changes are continuously impacting the stock market volatility. The volatility of stocks in the future can help us make essential trade decisions that increase profits and prevent losses. IV is calculated by using the Black-Scholes model for option pricing. 

 

• Future Realised Volatility

 

Future realized volatility is the volatility of future events. There is no specific calculation for this metric, but it is derived from the previous future realized volatilities and their past predictions. It is not known in advance but gives a sense of how accurate the predictions of future volatility have been in the past.

 

 

What are the Factors Affecting Volatility?

 

• Underlying Stock

 

The events relating to the underlying stock impact the stock volatility. It increases any negative or highly optimistic news about the company.

 

• World Events

 

World events are not guided or influenced in a particular direction easily. However, in some rare cases, the financial crisis dawns upon the world’s economies, which remarkably increases inconsistency. Unfortunately, there are hardly any instances of positive world events increasing the inconstancy of stock markets worldwide. 

 

• Expiry Date of a Contract

 

Volatility has direct application in the derivatives market, specifically in options pricing. If the expiry date of a contract is farther, the volatility will be high, and option pricing will be markedly impacted. However, when expiry is near, the impact of volatility is superseded by the time decay of the option price. Hence, there is less impact of volatility on the option price.

 

 

Interested in how we think about the markets?

 

Read more: Zen And The Art Of Investing

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