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Volatility refers to the amount of uncertainty or risk related to the size of changes in a security’s value. A higher volatility means that a security’s value can potentially be spread out over a larger range of values. This means that the price of the security can change dramatically over a short time period in either direction. A lower volatility means that a security’s value does not fluctuate dramatically, and tends to be more steady. In other words, volatility is a measure of risk.
Then, how do we calculate volatility of a stock ?
One measure of the relative volatility of a particular stock to the market is its beta. A beta approximates the overall volatility of a security’s returns against the returns of a relevant benchmark (usually the S&P 500 is used). For example, a stock with a beta value of 1.1 has historically moved 110% for every 100% move in the benchmark, based on price level. Conversely, a stock with a beta of .9 has historically moved 90% for every 100% move in the underlying index. Volatility of a stock can also be measured by finding out the variance and standard deviation of that particular stock. The standard deviation of the stock gives the investors a rough idea about the amount by which the price of the stock can shift in either direction.
So the question arises, how does the market become volatile ?
Volatile markets are usually characterized by wide price fluctuations and heavy trading. They often result from an imbalance of trade orders in one direction (for example, all buys and no sells). Some say volatile markets are caused by things like economic releases, company news, a recommendation from a well-known analyst, a popular initial public offering (IPO) or unexpected earnings results. Others blame volatility on day traders, short sellers and institutional investors.
This puts forward another question, how does volatile markets affect investors ?
For the day trader volatility is a two edged sword. If a trading range can be identified, then the higher the volatility means the greater the spread between levels of support and levels of resistance. And this means the greater the opportunity to make profits: if the spread between low and high points is 10%, then a buy and sell round trip transaction will offer a wider margin than a stock that trades with an upper and lower price differential of, say, 2%.
Now something else that a trader has to be wary of is that the downside of a stock with higher volatility is larger than one with a lower volatility. Placing a stop loss at 2% down in a stock that often moves by 8% or 10% will mean that the trader has a greater chance of seeing the stop loss executed, writing in many small losses. So a trader must be willing to accept a larger downside if his trade turns sour, to stop unnecessary smaller losses mounting up.
For the long term investors, a way to deal with volatility is to avoid it altogether. This means staying invested and not paying attention to the short-term fluctuations. Sometimes this can be harder than it sounds; watching your portfolio take a 50% hit in a bear market can be more than most can take. If you find a company with a strong balance sheet and consistent earnings, the short-term fluctuations won’t affect the long-term value of the company. In fact, periods of volatility could be a great time to buy if you believe a company is good for the long-term.
In conclusion, it can be said that Volatility is one of the most misunderstood terms in stock markets. It comes as a part and parcel of trading in stock markets and if used correctly and accurately, it can be of immense use to both short term traders and long term investors who can benefit greatly out of it and earn huge amount of profits.
D-Street Research Wing