What is Volatility and How Does it Affect Your Investment?

What is Volatility

In the world’s stock markets, volatility is one of the most misunderstood concepts. The change in price that a stock or equity experiences over any given period of time is known as volatility. Any security which has a stable price is known to have low volatility. Whereas, a stock with high volatility will set new highs and lows frequently and also move erratically. Highly volatile stocks have rapid increase and dramatic falls.

People usually experience the pain of loss more acutely as compared to the joy of profits. Volatile stocks which rapidly show price fluctuations are considered to be a risky proposition buy the investors, but that is not the case. Volatility provides enormous opportunities to extract profits for seasoned traders and patient investors. Volatility does have high risk, but the risk work in both ways, which means that with every trade there is an associated risk of both success and failure. With low volatility the risk is also lower.

Types of Volatility

Volatility is a very important factors which investors and traders consider before entering in any trade in the financial markets. However, volatility has two different key approaches. Let us discuss about them in detail:

1. Implied Volatility: Implied Volatility is a common feature of the options market. It refers to the estimated volatility of an asset and reflects the views of marketplace where volatility should be in the future, but it provides no idea about the direction in which the price of the asset could move. Usually, implied volatility of an asset rises in bear market due to the fact that investors believe that the price of the asset will drop over time. In case of a bull market the implied volatility is low because it is believed that the price is bound to rise with time. This is due to the misconception that bear markets are inherently riskier when compared to a bull market. Implied volatility is one of the most prominent measures used by the traders to have an idea about the fluctuations in future in the price of an asset based on various predictive factors.

2. Historical Volatility: Historical Volatility is also referred to as Realised Volatility. It is used to statistically measure the dispersion of returns from a market index or particular asset over any given time frame. Average deviation of a financial instrument from its average price over a given time period is established in order to measure historical volatility. The most common measure for historical volatility or realized volatility is standard deviation. All those securities which have a high historical volatility are considered high risky securities. Though this is not a negative factor because both bullish and bearish runs can be risky. Historical volatility also acts as the baseline measure with implied volatility defining the relative value of assets prices.

Calculating Volatility

Standard Deviation and Variance are used to calculate volatility where, standard deviation is the square foot of the variance. The relative volatility of a stock is calculated using Beta. Beta is the approximation of the overall volatility of the returns of a security against the returns of a benchmark index. For example, a stock which has a beta value of 1.1 has moved 110 per cent for every 100 per cent move in the respective benchmark based on price level. On the other hand, a stock with a beta value of 0.8 has moved 80 per cent for every 100 per cent movement in the underlying index.

How volatility affects Trader Sentiments

Financial data analysis requires you to analyze market sentiments. Stock market has a stochastic behavior which means that the price of all listed stocks and other assets will naturally move up and down on a daily basis. But, still billions of investors from across the world trade and invest in the stock markets for extracting returns. The volatility of the stock market is of interest to investors because returns and risk are the entities which are directly proportional to volatility. With a highly volatile market, the chances of returns are also high and so is the associated risk. So, a highly volatile market provides you higher returns with higher risks.

Stock markets and volatility go hand in hand, but it totally depends on the investor to fear the volatility or make the most out of it. However, if you are not experienced in the markets, it is better to stay away from a volatile market because it can wipe out a considerable portion of your portfolio. If you still, want to trade in a volatile market to utilize the opportunities, it is better to get the services of a SEBI registered investment advisor who will provide you research based recommendations for trading in the stock market.

Happy Trading!