The term ‘volatility’ is thrown around the financial markets commentary by the professionals and press in the field. However, the average investor does not fully comprehend the concept behind it.
What is volatility? It is the measure of the rate of fluctuation in security prices over time. It represents the level of risk that comes with the changes in prices. Investors use volatility to assess past variations in security prices to predict future movements.
We use both standard deviation and the beta to determine the volatility. The standard deviation shows the amount of dispersion in the prices of a security.
The beta establishes the volatility of a security relative to that of the market. One can use regression analysis to calculate the beta.
There are different types of volatility which include
- Price Volatility
Three factors bring about changes in demand and supply and thus, volatility in pricing. The first one is the seasonality. For example, during the festive season, hotel prices in prime destinations rise and drop once the holidays are over.
The other factor is the weather. Agricultural product prices depend on the supply; therefore, when the weather is favorable, the prices are a bit lower. The third one is emotions. When there is uncertainty in traders, it affects the prices of the commodities they are buying.
- Stock Volatility
Some stock prices are very volatile due to unpredictability. As such, investors demand a higher return when the risk involved is high.
Companies whose stock is very volatile must grow profitably and show a steep increase in earnings and stock prices overtime to pay the investors high dividends. Investors compute the beta through regression analysis to know how well the stock prices correlate with the S&P 500 Index.
- Historical Volatility
This type of volatility shows the standard deviation of the changes in prices of a stock relative to its historic price over a specific period, say 12 months.
If the variation is wide, then it shows the stock is highly volatile and riskier and therefore less attractive.
For such a share, you will hold it for an extended period before the prices get to a point where you can sell and make a profit. Studying the chart helps you tell if it is at a low point. However, with highly volatile stocks, it is quite unpredictable.
- Implied Volatility
It is a key parameter used in options trading. It represents the volatility of the prices of an underlying asset. How much the futures options vary enables traders to tell the implied volatility.
If they start rising, then it shows that volatility increases as well. For options traders, they can buy options on securities which they think are volatile and once the prices increase, sell them for a profit.
- Market Volatility
It measures the price changes in any market. It includes the forex, commodities and stock markets. Increase in volatility shows that there is a market top or bottom at hand.
In conclusion, volatility doesn’t measure the direction in which prices will change but only the dispersion. With more in-depth understanding, traders can use these types of volatility to their advantage.