What Is Market Volatility
Understanding Market Volatility
The best way to make the most of your investments is to fully understand every aspect about them - including the ways that outside factors can impact your money. Learning more about market volatility can help you make wise choices and understand how much risk you’re really taking on.
What is Market Volatility?
Market volatility is the term used to describe the ups and downs investments can make as the market fluctuates. Assessing market volatility is one-way smart investors measure how well an investment is performing (or likely will perform) over time. It can offer an idea of how risky an investment or vehicle may be.
Causes of Market Volatility
It’s easy to check in on your own investments and see fluctuations in value, but what causes volatility across the financial markets as a whole? There are usually a few distinct reasons markets can fluctuate:
- Imbalance in Buying and Selling: Volatility in the market is often caused by an imbalance between buying and selling. If many more people are selling than buying (or vice versa), it can increase volatility and instability.
- Price Fluctuations: Wild or regular price fluctuations can trigger a more volatile marketplace.
- New Product Launches: A major company with a big, new, exciting product can cause volatility, as consumers rush to invest after the buzz becomes mainstream.
- Major Brand With Major Problems: A well-known brand with financial, legal or social woes can quickly trigger volatility, as investors act fast to try and sell off and flee the brand.
- Unanticipated Quarterly Results: Unexpected figures in a quarterly or annual report can often result in volatility.
- New Notoriety: A recommendation of a brand or company by an analyst or influencer with a large following can trigger a volatile situation.
How is Volatility Measured
You now understand at least a little bit about what is volatility in finance, but you still need to know how it’s measured. Since it’s a measurement of the degree an investment is increasing or decreasing, volatility in finance is described and measured two ways, by VIX or by beta.
VIX: The Volatility Index (VIX) is a measurement and prediction of what to expect from the entire stock market overall in the next 30 days. Created by the Chicago Board Options Exchange (CBOE), VIX figures can actually have a direct impact on volatility, even as they seek to describe or predict it.
Beta: Beta is a benchmark measurement that helps reveal how volatile a specific investment is in relation to the S&P 500 index. If an investment or time period fluctuation is higher than beta, it’s considered to be very volatile. If it’s lower than the beta figure, it’s considered to be less volatile.
How to Calculate Volatility
If understanding volatility is important, knowing how to calculate it is essential. Use the following steps to determine what volatility may be on any investment you’re considering or that you already have.
- First, find the mean - This gives you the average price of the stock in the time period measured. To figure out mean, you add the total cost of each day for a certain time period - let’s say you’re doing 10 days. Then divide by that number of days (10). The resulting number is your mean.
- Then, calculate deviations - Days that fall above or below the mean are considered deviations. If your calculated mean is 10, and the closing cost was $6 on one day, then the deviation for that day is $4 (10 - 6 = 4).
- Determine how widely the stock price varies - Add up and average the deviations over a set time period to get an idea of how widely the stock varies in price. A high number here indicates a volatile stock. A low number would suggest a less volatile investment.
Examples of Volatility
If you’re starting or building your portfolio, you’re smart to consider volatility. Many investors seek out less-risky investments in the beginning. But keep in mind, your risk tolerance (what you’re willing to bet) can, and probably will, change with experience.
The volatile market we’re currently seeing isn’t a novel experience. And while the global pandemic does have a lot to do with these wild fluctuations we’re witnessing, we have seen similar markets in the past, too.
For example, we also saw swinging unpredictability during other times of world-impacting events - from the Spanish Flu in 1918 to World War II in the 1940s. And we can’t forget the market crash on Black Monday in the 1980s. Large scale and global events are often tied to market volatility.
Keep in mind, some stocks are considered to have high volatility in general, regardless of market conditions. Think: GameStop, Boeing and (of course) for a very timely example, vaccine makers like Moderna come to mind.
How to Profit From Market Volatility
Now that you know what it is, how can you profit from market volatility? While it may seem counterintuitive at first, when you know what you’re doing, and understand how to use it to your advantage, there are actually several ways to profit from volatility.
A buyer puts in an order for both a call option and a put option at the same maturity date. This is like backing all of the horses in a race - you win regardless of whether the market goes up or down. Understandably, a highly volatile market is needed to maximize profits using this strategy. Somewhat surprising to new investors is that the Straddle strategy relies on very big swings, in either direction.
Another strategy that bets on volatility is the Strangle strategy. Here, buyers use a long term strategy that costs less money (and therefore increases profits). The Strangle strategy requires traders to use what’s known as Out of the Money (OTM) options to invest, resulting in lower overall costs. If you think a security will see a big swing in movement (again, in either direction), using the Strangle strategy might be a good idea.
Now that you've learned what volatility is, you can better understand some of the beneficial ups and downs your own portfolio takes over time. Whether you decide to employ a strategy to profit from a volatile market or not, knowing what volatility means in relation to investing can only make you savvier as you build your portfolio!
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