What Is Volatility in Simple Terms?
Volatility is the degree to which a security (or an index, or the market at large) varies in price or value over the course of a particular period of time. Volatility refers to both the frequency with which a security changes in price and the severity with which it changes in price. Typically, the more volatile a security is, the riskier of an investment it is. That being said, more volatile securities may also offer more substantial returns.
Risk-tolerant investors interested in growth tend to like volatile securities and markets because of their higher potential upside, whereas risk-averse investors who prefer modest-but-stable returns and lower risk tend to steer clear of highly volatile investments.
What Causes Volatility in the Market?
When it comes to the market as a whole, volatility is often related to macroeconomic factors rather than industry or company-specific issues. These can include things like abnormally high or low inflation, interest rate hikes, geopolitical events like international conflict, economic recessions, supply-chain issues, and even so-called forces majeures like environmental catastrophes or viral outbreaks like the COVID-19 pandemic. In many cases, a combination of these types of factors may catalyze market-wide volatility.
During periods of market-wide volatility, risk-averse investors tend to move their money toward safer, more stable securities like precious metals, government bonds, or shares of preferred stock, depending on individual risk tolerance.
What Causes Volatility in Particular Stocks?
Individual stocks can experience volatility independent of the market at large. Some stocks are known to be more volatile than others, and generally, the higher a stock’s trading volume is, the more volatile it is likely to be. Well-known companies that are constantly in the public eye (think Tesla, Amazon, Meta, etc.), have a large market cap, and experience huge daily trading volume are naturally more volatile than lesser-known stocks that don’t have as public a persona and aren’t traded as heavily.
Individual stocks can also experience short-term volatility around certain events. The release of a new product; the hiring, firing, or retirement of an executive; or the buzz surrounding an upcoming earnings call can all send a stock’s price for a temporary tailspin until things have settled down.
How Can Investors Benefit From Volatility?
There are many ways investors can incorporate volatility into their trading strategies, but all involve risk. An average, buy-and-hold value investor could identify a few stocks they like, keep an eye on price movements and volatility, then buy into each stock when its price seems relatively low (i.e., when it approaches an established support level) so they stand to gain more when the stock’s price goes back up in the longer term.
More active, shorter-term investors (like day traders and swing traders) use volatility to make buy and sell decisions much more frequently. Day traders aim to buy low and sell high multiple times over the course of a single day, and swing traders do the same over the course of days or weeks. Both types of traders use short-term price volatility to profit off of trades.
Options traders who simply want to bet on high volatility but aren’t sure if the price of a stock will go up or down may buy straddles (at-the-money put and call options for the same stock that expire at the same time) so that they can profit off of price movement in any direction.
How Is Volatility Measured?
There are a number of ways to measure and interpret volatility, but most commonly, investors use standard deviation to determine how much a stock’s price is likely to change.
What Is Standard Deviation?
Standard deviation tells us how much a stock’s price was likely to change on any given day (in either direction—positive or negative) over a particular period.
How Do You Calculate the Standard Deviation of a Stock’s Price?
- To calculate standard deviation, first choose a time period (e.g., 10 days).
- Take an average of a stock’s closing prices for that period.
- Calculate the difference between each day’s closing price and the stock’s average closing price for that time period.
- Square each of these differences.
- Add the squared differences up.
- Divide this sum by the number of data points in the set (e.g., if the time period is 10 days, divide the sum by 10).
- Take the square root of the result to find the stock’s standard deviation for the period in question.
The resulting number will be in dollars and cents, so comparing standard deviation between two stocks can’t tell you how volatile they are in comparison to one another because different stocks have different average prices. For instance, if stock A has an average price of $200, and stock B has an average price of $100, a standard deviation of $5 would be a lot more significant in stock B than stock A.
To compare standard deviations between stocks, use the same time period to calculate a standard deviation for each stock, then divide each stock’s standard deviation by its average price over the period in question. The resulting figures are percentages and can thus be compared to one another more meaningfully.
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Standard Deviation Calculation Example: Acme Adhesives
Let’s say we want to find the standard deviation of the stock price of a fictional company called Acme Adhesives over the course of a particular five-day trading week. Let’s assume the stock closed at $19, $22, $21.50, $23, and $24 that week.
First, let’s find the average closing price for the week.
Average = (19 + 22 +21.50 + 23 + 24) / 5
Average = 109.5 / 5
Average = 21.9
Next, we need to find the difference between each closing price and the average closing price for the five-day period in question.
19 – 21.9 = -2.9
22 – 21.9 = 0.1
21.5 – 21.9 = -0.4
23 – 21.9 = 1.1
24 – 21.9 = 2.1
Next, we need to square each of these differences.
(-2.9) * (-2.9) = 8.41
0.1 * 0.1 = 0.01
(-0.4) * (-0.4) = 0.16
1.1 * 1.1 = 1.21
2.1 * 2.1 = 4.41
Next, we need to add these squared differences up.
8.41 + 0.01 + 0.16 + 1.21 + 4.41 = 14.2
Next, we need to divide this sum by the number of data points in the set (i.e., the number of days we’re looking at)
14.2 / 5 = 2.84
Finally, we need to take the square root of this result.
√ 2.84 = 1.69
So, the standard deviation of Acme Adhesives’ stock price for the five-day period in question is $1.69. If we divide this by the stock’s average price for the time period ($21.90), we get 0.077, which tells us that the stock’s price was likely to deviate from its mean by about 8% each day during that period.
What Is the Volatility Index (VIX)?
The volatility index, or VIX, is an index created by the Chicago Board Options Exchange designed to track implied market volatility based on price changes in S&P 500 index options with upcoming expiration dates.
Analysts look to the VIX as a measure of fear and uncertainty in the investment community because it represents the market’s volatility expectations for the next month or so. Because the S&P 500 tracks 500 of the biggest U.S. stocks by float-adjusted market capitalization, it is thought to be a good representation of the American stock market, and subsequently, the VIX is thought to be a good representation of the American stock market’s short-term volatility expectations.