When we
talk about volatility, we usually think of it as something as vague as the “prices’
movement, whether higher or lower, and the enormity of its swings.
However, that’s
just a simplification of a concept that consists of different types. Let’s get
into what those types are.
Price
Volatility
Price volatility
refers to the volatility of a stock or security with regards to the supply and demand.
There are
three factors that affect price volatility: the seasonality, the weather, and
the emotions.
Seasonality
As its name
suggests, seasons affect the price volatility of different assets and
securities. One business, for instance, may perform well during summer, but not
during winter. Thus, that company’s stock value gains more during peak seasons,
while slumps during down times.
Changes in
demand affect the stock prices and value, and therefore affect its volatility.
Weather
Weather also
affects demand and supply.
This can be
well-observed in commodities and agricultural sectors in which weather is a
primary concern all the time.
The weather should be favorable enough if the crops were to be bountiful. Thus, if you’re
investing in real estate and staple products, and the weather is turbulent, you
can expect much volatility in your investments.
Emotions
Of course, one
of the biggest factors that affect price volatility is the traders’ and
investors’ emotions.
Whenever market
participants feel worried about a particular issue, any industry or sector
associated with that issue would definitely be affected.
Commodities
can again be a very good example for this. Whenever geopolitical disputes
occur, oil prices react erratically. This is due to investors worrying about
the trade and foreign relations of the countries involved. It would be extra
turbulent once one of the countries is a commodity-heavy nation.
Stock
Volatility
Some stocks
sport prices that are extremely volatile, while others barely move.
This means
that you’re calling on more risks when you invest in stocks. You would want to
have a higher return for the increased uncertainty. When a company has a very
volatile stock, it needs to have more profitability. That means that company needs
to obtain a drastic increase in earnings and stock prices as time goes by. They
can also pay high dividends.
Beta
Throughout the
years, investors have designed a measurement for stock volatility. This is
called the beta.
Beta measures
the volatility or the systematic risk of a security in a portfolio, while comparing
to the overall market. It uses in the capital asset pricing model, which in
turn checks the expected return of an asset using its beta and expected market
returns. An asset’s beta can be calculated using regression analysis.
For more
advanced traders, remember that you should only use a security’s beta when it
has a high R-squared value in connection to the benchmark. R-squared, in turn,
measures the percentage of security’s historical price movements that the
movements in a benchmark index could explain.
For instance,
suppose you try to know the tendencies of a stock you are holding. You use its
beta to know how much it is correlated with the S&P 500 Index. If it moves perfectly
alongside the index, the stock’s beta is 1. If it’s higher than that, it’s more
volatile than the index. If, on the other hand, its beta is less than 1, it’s
not as volatile as the index.
Historical
Volatility
Historical volatility
refers to the amount of volatility a stock has had over the past year or 12
months.
When you
see that the stock price varied widely during that period, it tells you that it’s
more volatile, therefore riskier. It becomes unattractive for investors who are
risk-averse.
But that doesn’t
mean it can’t be profitable. You might only have to hold on to it for a longer
time before the price can jump back to a level where you can sell it for a
profit.
It then
follows that you should study and research some charts and analyses. That’s for
you to know if the stock is in its low point or high point. Once you can spot
those points, you would know when to hold and when to sell it again to get some
profits. Thus, knowing and understanding a stock’s historical volatility will
help you timing the market right.
On the other
hand, highly volatile stocks can go tremendously lower for an extended period before
it can go up again. It’s also highly unpredictable.
Implied
Volatility
When we
talk about implied volatility, we refer to the amount of volatility that
options traders think the stock will have in the future.
In order to
understand the implied volatility of a stock, you would have to look at how much
the futures options prices vary.
If you see
that the options prices are already rising, the implied volatility is also increasing.
If you want
to use it to your advantage, you can buy an option on a stock if you see strong
indications that it will get more volatile. If you hit the bull’s eye, the option’s
price will get higher, which means you can go sell it for a profit. Remember that
the best time to sell an option is when it gets less volatile.
The Volatility
Index or the VIX measures the implied volatility of the S&P 500. Created by
the Chicago Board Options Exchange in 1993, it uses stock option prices and
gauges investor sentiment. The VIX has earned the nickname “fear index.”
Normally, when the VIX is high, stock
prices slide.
Market
Volatility
Market volatility
refers to the velocity of price changes for any market, including the
commodities market, forex, and the stock market.
When there’s
a high level of volatility in the stock market, it typically means that the
market is nearing a market top or a market hand. This is due to a lot of
uncertainty.
Bullish traders
try to bid up prices during good days, where news is upbeat and company
outlooks are upbeat. On the other hand, bearish traders and short-sellers push
prices down during a bad news day.
Conclusion
Volatility is
a very major factor to consider whenever you make trade decisions. Therefore,
it’s just right that you know which type of volatility you are dealing with. You
should not disregard volatility.
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