What is Volatility?
Volatility is how much the price of a stock, cryptocurrency, commodity or product goes up and down over a period of time. High volatility means that the price changes a lot quickly, and can be unpredictable and highly variable.
There are many factors that affect volatility – market conditions, macroeconomic factors, supply and demand, investor sentiment and more.
In the securities market, volatility means the changes in the price of stocks, bonds or other assets. For example, if a company announces unexpectedly strong earnings, its stock price may spike, causing a sudden increase in volatility.
Volatility is how much the price of a stock changes over a period of time. In this way, there are two factors taken into account when calculating volatility: variance of price, and time.
Let’s understand both factors in detail.
Variance of Price
The price of an asset varies depending on many factors. If the demand for that asset suddenly increases, like in the case of face masks during the COVID-19 pandemic, the price of that asset will also increase.
Generally, the closing price of the asset is used in calculations of volatility. The closing price of a security is the price it was valued at when markets closed. In India, markets close at 3:30 PM.
Variance of price is the average squared deviation of the price of an asset from the mean, or average of the dataset. In other words, it quantifies how much the actual price of an asset varies from the mean of the dataset.
|High Variance||Low Variance|
|A high variance means that the price of the asset is fluctuating widely around the average of all prices in that period of time.||A low variance means that the price is relatively stable and close to the average.|
Variance of price is a measure of risk, since it tells us how unstable an asset is. But if an investor needs to know how a particular asset would perform in the future, time would have to be taken into consideration as well.
Periods of Time
To predict the uncertainty of an asset in the future, we need to take into account the amount of time along with the price of the asset.
By taking the periods of time into consideration, we get both the magnitude and direction of change in the price of the asset.
To get the volatility of the price of an asset, investors multiply the standard deviation (which is calculated from the variance of price) with the squared root of the number of periods in the time horizon.
Formula for Volatility
The formula to calculate the volatility of price is = standard deviation of returns ✕ √number of periods in time horizon.
Or, more simply:
vol = σ√T
Example for Volatility Calculation
To better understand how volatility is calculated, let’s make use of a hypothetical situation.
Assume we want to calculate the price volatility of a stock over the past five trading days. We have the following prices:
Day 1: $100
Day 2: $105
Day 3: $98
Day 4: $102
Day 5: $110
To calculate price volatility, we first need to calculate the average or expected price over the period. In this case, the average price is:
Average Price = (100 + 105 + 98 + 102 + 110) / 5 = $103
Next, we calculate the deviation of each price from the average:
|Day 1||Rs 100||Rs 103||-3|
|Day 2||Rs 105||Rs 103||2|
|Day 3||Rs 98||Rs 103||5|
|Day 4||Rs 102||Rs 103||-1|
|Day 5||Rs 110||Rs 103||7|
Note that we take the absolute value of each deviation, as we are only interested in the magnitude of the difference, not the direction.
Then, we calculate the average deviation:
Average Deviation = (3 + 2 + 5 + 1 + 7) / 5 = 3.6
Finally, we calculate the standard deviation of the price changes by taking the square root of the average deviation squared:
Price Volatility = √(3.6^2) = 3.6
So the price volatility of this stock over the past five trading days is 3.6.
Note that this is a simplified example and in reality, there are different methods to calculate the price volatility, such as using logarithmic returns, and other factors to consider such as outliers and longer time periods.
High volatility indicates that the price of the security is fluctuating rapidly and unpredictably, while low volatility suggests a more stable and predictable price.
Traders and investors use measures such as standard deviation, beta, and the VIX (volatility index) to gauge the volatility of a security or market. In India, investors use the India VIX, otherwise known as the “fear gauge”, because it reflects the level of fear or uncertainty among traders and investors.
If India VIX is high, it suggests that there is a greater likelihood of sharp movements in the stock market. Conversely, if India VIX is low, it indicates that the market is relatively stable and that there is less fear or uncertainty.
When analyzing volatility, it’s also important to consider the underlying factors that may be driving price movements, such as economic data, company news, geopolitical events, or market sentiment.
By interpreting volatility in the context of these factors, traders and investors can make more informed decisions about when to buy, sell, or hold a particular security.
Types of Volatility
There are several types of volatility that investors and analysts commonly use to measure the risk and uncertainty of an investment:
This type of volatility is calculated by measuring the actual changes in an asset’s price over a specific period of time, such as the past month, quarter, or year. It is often calculated as the standard deviation of returns over that period.
Implied volatility is calculated based on the prices of options contracts on an underlying asset. It reflects the market’s expectation of future price movements in the asset, as implied by the prices of options with different strike prices and expiration dates.
Realized volatility is the actual volatility experienced by an investment over a given period of time. It is calculated by measuring the actual changes in the price of the investment over that period.
Generalized Autoregressive Conditional Heteroskedasticity) is a statistical model that takes into account the fact that volatility tends to cluster over time. It is commonly used to forecast future volatility based on past data.
Parkinson volatility is a measure of volatility that takes into account the high and low prices of an asset, as well as the closing price. It is calculated as half of the difference between the highest and lowest prices, divided by the square root of two times the closing price.
This is another measure that takes into account the high, low, and closing prices of an asset. It is calculated as the square root of the sum of the logarithmic returns squared, multiplied by a scaling factor.
Range volatility is a measure of volatility that takes into account only the difference between the high and low prices of an asset over a specific period of time.
These are just a few examples of the different types of volatility that exist. Each type has its own strengths and weaknesses and is suited to different applications and investment strategies.
In times of high volatility, investing without accounting for future uncertainty can lead to losses. This is even more important for businesses, which invest much more money than individual investors and, as a result, are more vulnerable to huge losses.
Here are some tips for founders and individual investors to keep in mind when investing:
Diversify Your Investments: A strong, well-diversified portfolio will protect you against market uncertainties by reducing the impact of sharp downturns. Diversifying your portfolio means investing in a range of different types of assets and risk types.
Read more: Building a Well-Diversified Portfolio
Maintain Cash Reserve: Keeping a cash reserve can help you to weather periods of market turbulence without having to sell investments at a loss. Consider keeping a cash reserve of three to six months’ worth of living expenses to help you stay financially stable during times of volatility.
Strong Financial Backup: Apart from investing money in securities, businesses should make sure to park their finances in reliable, secure Current Accounts. Apart from offering a safe place to keep your cash reserve, fintech solutions like RazorpayX provide account holders with everything they need to manage their finances:
- Payroll Management
- Vendor Payments
- Corporate credit cards
- Tax Payments
- Forex and FDI Transfers
- Coordinating with CA and finance teams
What causes volatility in financial markets?
Volatility in financial markets can be caused by a variety of factors, including changes in economic data, company news, geopolitical events, and market sentiment. For example, if there is positive economic news, such as strong job growth or increased consumer spending, this may lead to a rise in stock prices and a decrease in volatility.
How can investors protect themselves from volatility?
Investors can protect themselves from volatility by diversifying their portfolios and investing in a mix of assets such as stocks, bonds, and commodities. Diversification helps to spread risk across different asset classes and can help to reduce the impact of volatility on a portfolio.
What is the relationship between volatility and risk?
Volatility and risk are closely related, but they are not the same thing. Risk refers to the potential for loss, while volatility refers to the degree of fluctuation in the value of an asset. Generally, higher volatility is associated with higher risk because there is a greater chance that an asset's value will decline.