The stock market often demands roller-coaster ride. Sometimes, growth can be so fast only in the matter of a few days before crashing down the price. Such unpredictability and fluctuation in the security’s price are often termed as “volatility.” There has been one of the paramount concepts in the financial markets with it suggesting the degree of price of an asset over time with deviation.
Volatility is the hallmark of risk management and informed decision-making on the part of investors and traders. The article below presents an overview of the various types of volatility: historical volatility, implied volatility, volatility smile, and skew and their possible applications in the risk minimization and returns optimization.
Volatility, while often seen as a source of risk, also presents significant opportunities for profit. Understanding how to measure and manage volatility effectively can turn this market characteristic into an asset.
Understanding Volatility in the Stock Market
Volatility in a stock market means the price movement of the security over the period. A volatile asset implies that an asset has frequent price movements on either side; a less volatile asset is stable. Economic reports, political events, company fundamentals, and investor sentiment are some of the factors contributing to volatility.
Uncertainty in markets is usually characteristic of high volatility, whereas low volatility describes stable markets. Markets tend to be unstable and volatile when the economy is unstable either economically or politically since investors act to uncertain events.
Volatility needs to be understood well to manage the risk appropriately to build an investment strategy. High volatility will drive investors seeking safer investments and a low volatility environment will make investors search for more risk, the higher return opportunities.
Historical Volatility
Just refers to the history of the price volatility of security over past. This measures the degree of the history of the returns over the asset, and normally it is that achieved over some period of standard deviation. From this, an investor can infer how volatile the stock is/was, and thus hence will be by risking understanding. Thus, in judging the historical volatility of how far away a stock has deviated from its normal stock price, it is assisted
How to Calculate Historical Volatility – Step to compute Historical Volatility:
- Take past price history for the stock during any length of time.
- Daily percentage change in the stock price.
- Compute standard deviation of daily return over the period.
- Multiply the standard by the square root of the number of trade days in a year –( 252 for the daily data).
Example:
If the historical volatility of a stock is 25%, it then means that, on average, the price of the stock had moved 25% per year from the mean price for the past years. Traders usually use only historical volatility to estimate the amount of prices that would move, and therefore they would know how much risk is involved in holding an asset within a certain time.
Implied Volatility
Implied volatility represents what the market believes is the volatility in future price movement. As opposed to historical volatility, which relies on past data, implied volatility looks into the future. It depends on what the investor feels about the future.
It forms from the price of the option. Option prices usually go up with a signal that more expected volatility exists in the price. Implied volatility is most used in the formula of options pricing. It does give insight to investors about market expectations over the volatility of a particular underlying asset.
High implied volatility implies that the market expects huge moves in the future. Low implied volatility simply means the market expects not much movement in prices. Implied volatility is quite crucial while pricing options. Options traders require implied volatility to estimate where the market stands and then build up their strategies.
Normally, higher level of implied volatility tends to increase more premium for options which means costlier options, whereas it will be cheaper to buy the options by lower implied volatility.
Relationship Between Historical and Implied Volatility:
- This history of volatility is based upon the past movements of prices, and it is showing us exactly how much something has been moved in the past.
- Implied volatility, however, is more a consequence of market sentiment and how much volatility one can expect to happen in the future.
- The difference here is that this historical volatility is factual; hence, the implied one is speculatory and based on the sentiments prevailing in the market.
There is also identification of gaps between historical and implied volatility where an investor finds discrepancies as the potential opportunities. For example, when the implied volatility is much higher than historical volatility, it could mean that the market is waiting for significant events or uncertainty.
The lower the implied volatility is from historical volatility, it means a complacent market that would jump to price in case volatility goes up unexpectedly. Besides these historical and implied volatilities, there are related concepts in the same genres- those being volatility smile and skew, which become very vital in trading options.
Volatility Smile and Skew
Another important aspect of options trading is the concept of volatility smile or skew apart from historical and implied volatilities.
Volatility Smile: Implied volatility of options at any strike price can graphically be illustrated as a volatility smile. In general, as the prevailing market strikes move farther and farther from the prevailing market, implied volatilities of options increase and actually form a curve that actually resembles a smile.
This smile volatility indicates that options having strike price far more significant or much lower than the prevailing price are relatively costlier because those are very riskier options carrying relatively higher levels of uncertainty. Conversely, at-the-money is expected to carry relatively lower levels of implied volatility.
It, therefore, shows the traders how much difference in terms of implied volatility exists when the market adjusts its relative position with regard to a fixed strike price using a volatility smile.
Volatility Skew: A volatility skew is the fact that implied volatility is asymmetrically skewed due to differences for different strike prices, especially when instances arise such that the implied volatility of puts is relatively more compared to call options than in markets.
This mainly takes place in equity markets since the market traders are willing to purchase a bigger premium for insurance on the downside in vague or bearish market conditions. It depicts that at any given level of volatility, as the strike price moves upwards, it is commensurately low and vice-versa.
The trend is also much more prominent for an out-of-the-money put options. This reveals that, apparently, the market prefers the downside risk. However, knowledge about volatility skew will be vital for all options traders, who desire to ride on the market’s sentiments and hedge the proper risks.
Managing Volatility in the Stock Market
There is always volatility with stock markets. While on the other side, developers put and have put in place several techniques and methodologies with the express intention of smoothing its performances. However, controlling or managing the volatility depends on the evaluation of all the risks involved in downturns in markets and their fluctuations and their appropriate mitigation of losses from it.
- Diversification:
Diversification is the best way to handle volatility. Spread your investments over various asset classes, so that the overall risk decreases. When one asset class becomes very volatile, others might have gotten better. It works as a balance and tends to smooth out the overall returns.
Diversification also works on sectors and industries. A diversified portfolio which covers so many sectors will be vulnerable to any volatility in that sector. For instance, a portfolio which has some stocks on the tech sector as well as some on the utility sector will reduce its volatility than one only with tech stocks because of the stabilization effect of utility stocks.
- Hedging with Options:
Options, such as put and call options, are resorted to for hedging risks of volatility to avoid an erosion in stock. For instance, through a put option, one can safeguard himself from a drastic drop in the price of stock. Through hedging, the risk can be overcome without selling any asset since the long-term growth of such assets can be maintained while managing short-term volatility.
The strategies used can differ according to the risk tolerance and objective of the investor. For instance, some investors will hedge only a part of their portfolio whereas others will use rather complicated techniques such as options spreads to limit their exposure to price movements.
- Risk Tolerance and Position Sizing:
Volatility is such an important factor for those trading with it. An investor’s degree of exposure to market risk can be simply referred to as risk tolerance. Investors who are low on risk tolerance may invest in less-beaten-down funds, while higher-risk-tolerant investors may invest in more volatile assets, such as growth stocks or options.
Position sizing is the quantity that should be put into each position, taking into consideration the risk profile at large. Stocks with greater volatility also have to be balanced because greater volatility is bound to expose bigger positions to the risk factors and vice versa.
- Stop-Loss Orders:
The stop-loss orders hold the volatility since the amount sold automatically triggers off by an asset, given below a certain threshold, preventing its price from dropping low enough so as to cause massive loss due to the downturn in market. For example, the investor of stock can use stop loss orders for stocks if put at 10 percent in comparison to its existing rate through selling that particular stock for falling.
The stop-loss orders are really useful for an investor who cannot constantly keep an eye on his or her portfolio. It automatically controls the risk for losses that have already been incurred before a strong price movement.
5.Long-Term Investing:
Volatility is controlled with long-term investments. Even though the short time fluctuation is worrisome, volatility might overcome the long term investor as a whole because they usually see an upward trend in the market. Indeed, long term trend of stock market has usually had upward trend and ignored short fluctuation.
They are not much concerned about short-term fluctuations in the price; they are concerned rather about the long-run performance of investment. It is said quite aptly that this approach suits the time horizons and the nerves to bear with the market downfall.
- Dollar-cost Averaging:
This is the amount of money invested at regular intervals, irrespective of any market crisis. The impact of volatility will most likely get averaged over time and hence mitigated through this strategy. More shares are bought when the price goes low and fewer shares when up, thus lowering the effects of market volatility.
This would reduce the psychological impact of investing because it eliminates the temptation of trying to time the market. It is quite effective during volatile times because it allows an investor to take advantage of any price dips without necessarily trying to predict the movements of the market.
Conclusion
Volatility is a nature of the stock market but not something to be feared. The knowledge of historical and implied volatility also provides a notion of concepts about volatility smile and skew allow investors to better assess risk as well as make informed decisions.
The effective control of volatility would be achieved through diversification, hedging, understanding his risk tolerance, and using effective strategies such as stop-loss and dollar-cost averaging.
Volatility is the kind of thing that always gives way to trouble, but on its own, it offers challenges for the investors who can really work with it. The management of volatility could easily be done through the options trade, which would rather be used for a short-term period, or it would be the longer approach in terms of the use of the buy-and-hold investment technique.
For winning investors, management of volatility would become the key to victory when playing in financial markets. Know-how and initiative will then make market swings as channels for growth and increasing wealth.
FREQUENTLY ASKED QUESTIONS
- How to manage the stock market’s volatility?
- Volatility is controlled in the portfolio using diversification, hedging via options, stop-loss orders, a known risk limit, and an investment that stays long term. All this reduces exposure to fluctuations by the market and even loss.
- What is volatility in the stock market?
- The extent to which a security price changes over a given time is known as stock market volatility. It is commonly used to measure uncertainty in a price movement of an asset.
- What is the volatility of the stock market?
- Indices like VIX or Volatility Index are part of the traditional measures for stock market volatility. It presents the future market changes based on the investor’s possible predictions or expectations. High volatility describes a high degree of uncertainty with wide price movements.
- How to solve Volatility?
- While volatility cannot be fully “solved”, it can be managed with help of diversification, options hedging, techniques used in managing risk, and long-term investment horizon riding out market fluctuations.
- How to decrease the volatility?
- This would further reduce portfolio volatility as well through diversifying investments over different diversified asset classes and sectors accompanied by options strategies that work as protective hedges, all this would be accomplished coupled with the balance on account of your risk tolerance levels and your long-term goals.