Understanding Stock Market Volatility

Volatility is synonymous with the financial markets that have made and broken many investment careers. A double-edged sword, volatility makes it possible for investors to squeeze in profits over short periods in the financial markets. Conversely, even a slight mistake in times of high volatility can prove costly.

I. What Is Market Volatility?

Volatility is the rate or the frequency at which the price of a security in the market fluctuate by moving up and down. It is also the pace at which prices swing wildly as traders react to a number of developments or announcements in the markets.

A stock is volatile when its underlying price changes dramatically over a short period. This wild swing is gauged using a standard deviation tool that measures price departure from the average. Volatility is prominent during times of turbulence, as uncertainty usually causes investors to react emotionally, triggering wild swings in the market.

II. Factors Affecting Volatility

The wild price swings that come into play during the course of trading are usually the result of investors reacting to news. Economic factors such as interest rates and tax policies can cause investors to tweak their investment portfolios, triggering a change in the direction of the market.

For instance, whenever central banks increase interest rates, investors are often forced to target income-focused investments such as bonds, triggering a spike in prices. Higher interest rates can result in a decline in stock prices.

Inflation trends can also affect stock market trends and volatility. So can industry-specific news.

There are four main types of volatility measures:

•  Historical Volatility
•  Implied Volatility
•  The Volatility Index
•  Intraday Volatility

III. Historical Volatility

Historical volatility refers to the historical changes in asset prices. It is essentially a change in the price of a security or other financial instrument relative to a historical price. You can also envision historical volatility as the deviation of a security price from a given average.

IV. Implied Volatility

Implied volatility refers to the amount of volatility that traders believe a stock or any other security will have in the future. In the options market, you can tell the amount of volatility on a given stock by studying how options futures prices vary.

V. Volatility Indexes

Implied volatility and stock volatility are associated with individual stocks. Volatility indexes, on the other hand, refer to the amount of volatility associated with an index such as the S&P 500 or an exchange-traded fund such as the Spyders.

Volatility indexes are weighted averages of implied volatility for several options. Analysts rely on volatility indexes to gauge market sentiment given the weighted average.

VI. Intraday Volatility

Intraday volatility refers to price swings during the course of a trading day. It reflects the difference between the intraday high and intraday low, divided by the closing price of a security.