Anyone who is vaguely aware of the operation of the stock market must have come across the term “volatility” or volatility. Volatility is an ambiguous term that most often implies risk or uncertainty about how the stock market will move.
The article we are making now is discussing volatility in-depth, complete with its types, causes and how to calculate volatility.
Contents
1 What is Volatility?
2 Types of Volatility
2.1 Price Volatility
2.2 Stock Volatility
2.3 Historical Volatility
2.4 Implied Volatility
2.5 Market Volatility
3 What Causes Volatility?
3.1 1. Political and economic factors
3.2 2. Industry and sector factors
3.3 3. Company performance
4 Ways to Calculate Volatility
4.1 Case Examples
What is Volatility?
Volatility is a measure of the level of fluctuation in security prices from time to time. It indicates the level of risk associated with changes in the price of a security.
Investors and traders calculate the volatility of securities to assess past price variations to predict their future movements.
Volatility is determined using either the standard deviation or beta. The standard deviation measures the amount of the spread in the price of a security. Beta determines the volatility of the security relative to the market as a whole. Beta can be calculated using regression analysis.
Volatility Type
Price Volatility
Price volatility is caused by three factors that change prices. These three factors work by changing supply and demand. Here are 3 factors that cause price volatility Causes of Price Volatility:
Seasonal
The first is the season. For example, resort hotel room prices go up in winter, when people want to get away from the snow. They stop by in the summer, when the tourists are content to travel around. That is an example of the volatility of demand, and price, caused by the regular change of seasons.
Weather
Another factor that affects the villatility price is the weather. For example, agricultural prices depend on supply. It depends on the weather favoring a bountiful harvest. Extreme weather, such as hurricanes, can send gas prices soaring by destroying refineries and pipelines
Emotion
The third factor is emotion. When traders worry, they exacerbate the volatility of whatever they buy. That’s why commodity prices are so volatile.
The emotional status of traders is one of the reasons why gas prices are often very high.
For example, in February 2012, the United States and Europe threatened sanctions against Iran for developing nuclear weapons.
In retaliation, Iran threatened to close the Strait of Hormuz, potentially limiting oil supplies. Although oil supplies remained unchanged, traders bid oil prices up to nearly $110 in March. Gas prices rise to $3.87 per gallon.
Stock Volatility
Investors have developed a measure of stock volatility called beta. It tells you how well the stock price correlates with the Standard & Poor’s 500 Index.
If it moves perfectly with the index, the beta will be 1.0. Stocks with betas higher than 1.0 are more volatile than the S&P 500. Stocks with betas less than 1.0 are less volatile.
Economists developed this measure because the prices of some stocks are highly volatile. That uncertainty makes these stocks a riskier investment.
As a result, investors want higher returns for the increased uncertainty. Companies with highly volatile stocks need to grow profitably.
They must show dramatic increases in earnings and share prices over time or pay very high dividends.
Historical Volatility
Historical volatility or historical volatility is how much volatility a stock has had over the last 12 months.
If the stock price has varied greatly in the past year, it is more volatile and risky. It becomes less attractive compared to less volatile stocks.
You may have to hold it for a long time before the price returns to where you can sell it for a profit. Of course, if you study the chart and can tell at the lowest point, you might get lucky and be able to sell it when the price is high again.
It’s called market timing and it works best when it works. Unfortunately, with the stock being highly volatile, it could also be significantly lower for a long time before rising again
Implied Volatility
Implied volatility describes how much volatility options traders think the stock will have in the future.
You can tell what the implied volatility of a stock is by seeing how much variation the price of futures options varies. If the option price starts to rise, it means implied volatility is increasing, all other things being equal.
Market Volatility
Market volatility is the rate at which prices change for any given market. That includes commodities, forex, and the stock market.
Increased stock market volatility is usually a sign that a market peak or market bottom is near. There is a lot of uncertainty. Bullish traders bid prices on good news days, while bearish traders and short-sellers push prices down on bad news.
What Causes Volatility?
Some things that can cause volatility include:
1. Political and economic factors
Governments play a major role in regulating industry and can influence the economy when they make decisions about trade agreements, laws, and policies.
Everything from speeches to elections can trigger reactions among investors, affecting stock prices.
Economic data also plays a role, because when the economy is doing well, investors tend to react positively. Monthly jobs reports, inflation data, consumer spending figures and quarterly GDP calculations can all influence market performance. Conversely, if it misses the market’s expectations, the market may become more volatile.
2. Industry and sector factors
Specific events can cause volatility in an industry or sector. In the oil sector for example, a major weather event in an important oil-producing area can cause oil prices to rise. As a result, the share price of companies associated with oil distribution may rise, which is expected to benefit, while the price of companies that have high oil costs in their business may fall.
Similarly, more government regulation in a given industry may result in falling stock prices, as increased compliance and employee costs may impact future revenue growth.
3. Company performance
Volatility does not always apply across markets and can relate to individual companies.
Positive news, such as a strong earnings report or a new product that wows consumers, can put investors at ease with the business. If a lot of investors want to buy it, this increased demand can help raise the stock price sharply.
On the other hand, product recalls, data breaches, or poor executive behavior can all hurt stock prices, as investors sell their shares. Depending on how big the company is, this positive or negative performance can also have an impact on the wider market.
How to Calculate Volatility
The simplest approach to determining the volatility of a security is to calculate the standard deviation of the price over a certain period of time. This can be done using the following steps:
1. Collect previous stock prices.
2. Calculate the average price of the previous share price.
3. Determine the difference between each price in the set and the average price.
4. Square the difference from the previous step.
5. Add up the difference of the squares.
6. Divide the difference in squares by the total number of prices in the set (find variance).
7. Calculate the square root of the number obtained in the previous step.
Sample case
You want to know the volatility of ABC Corp. stock. for the last four days. The share price is given below:
Day 1 – $10
Day 2 – $12
Day 3 – $9
Day 4 – $14
To calculate price volatility, we need:
Find the average price:
$10 + $12 + $9 + $14/4 = $11.25
Calculate the difference between each price and the average price:
Day 1: 10 – 11.25 = -1.25
Day 2: 12 – 11.25 = 0.75
Day 3: 9 – 11.25 = -2.25
Day 4: 14 – 11.25 = 2.75
Square the difference from the previous step:
Day 1: (-1.25) 2 = 1.56
Day 2: (0.75) 2 = 0.56
Day 3: (-2.25) 2 = 5.06
Day 4: (2.75) 2 = 7.56
Add up the difference of the squares:
1.56 + 0.56 + 5.06 + 7.56 = 14.75
Find the variance:
Variance = 14.75 / 4 = 3.69
Find the standard deviation:
Standard deviation = 1.92 (square root of 3.69)
The standard deviation shows that the stock price of ABC Corp. usually deviates from the average price of its shares by $1.92.