What Is Volatility?
A generic definition of volatility describes how liable something is to change rapidly or unpredictably. In addition, it is usually (but not always) referred to with a negative connotation. So what does this term mean in the world of investing?
Well, the value of investments can change. It can go up or down. Volatility in investing refers to a statistical measurement of how likely it is that an asset’s price will change in value over a specific period of time.
A highly volatile stock may double in value within a month, or it might drop 90% in a week. However, even though the value can go up dramatically, most people do not perceive a volatile investment as a good thing. The reason being that you want your investments to be at least somewhat predictable.
Why Is Volatility Important?
Some stocks bring predictable returns, but overall, the stock market itself is a pretty volatile playing field. There is significant risk when investing in volatile stocks because, as the name implies, you know their values will probably change. However, you may not necessarily know whether that change will be positive or negative.
By measuring stock and market volatility, investors cannot only properly understand the risks concerning certain stocks and other investments, but they can harness that power of volatility in a way that may just work out in their favor.
How Is It Calculated?
What? Do you mean you don’t already know that volatility is calculated using standard deviation and variance, whereby the standard deviation is the square root of the variance? Well, that’s at least how the other investment websites would explain it to you. However, this is Finexy, so let’s break down the calculation the right way. Here are the steps:
- Calculate the average price of a stock for the specified time period. For example, when calculating the volatility of an asset for a 30-day period, you need to add up the closing price of the stock for 30 days, and divide that number by the number of days which is 30.
- Determine each period’s deviation by subtracting the closing price from the average price that you calculated in step #1 above.
- Get the square root for each of the deviations above.
- Add up all of the square roots together.
- Divide them by the number of periods observed. If using the same example from Step #1, you would divide your answer from step #4 by the number of days which is 30.
It’s important to remember that higher-priced stocks usually have a much higher volatility value than lower-priced stocks. For example, if a $500 stock moved up or down by $5 bucks, that’s a fairly small change. However, if a $10 stock goes up or down by $5 bucks, that’s a pretty significant change. So the higher standard deviation calculations because of a more expensive stock do not simply mean that that stock is more volatile.
Other Ways to Measure Volatility
There are a few other ways volatility is measured. The first one is the stock’s Beta (the symbol looks like this: β). Whenever you want to compare a stock’s volatility with a specific benchmark, such as other stocks in the same industry, you can check its Beta value. A stock with a Beta of 1.2 implies that the stock is 20% more volatile than the benchmark. A stock with a Beta of 0.7 indicates that it is 30% more volatile than the stocks in the same industry. Technology stocks typically have a higher Beta than the S&P 500. This means that when you add such stock to your portfolio, your portfolio risk increases but your return potential increases.
The VIX or Volatility Index, created by the Chicago Board Options Exchange, uses real-time stock quotes, as well as call and put options pricing as a way to predict the volatility of certain stocks over the next 30 days. Simply put, they’re using future “bets” from other investors to gauge how much the market will change in the near future.
What Is a Good Volatility For A Stock?
Let’s use the S&P 500 as the benchmark. Historically, the S&P 500 has had a standard deviation of 15.22% (as of 2020).
There were some years where the S&P 500 had almost incalculable volatility. One year, the S&P 500 only had 9 days that recorded a change of 1% or more. All other days it moved less than 1%. This was back in the 1960s, when the overall value of the benchmark was much lower. So, a 1% change wasn’t as big of a deal as it would be in today’s market.
With that being said, stock market volatility isn’t a “good versus bad” measurement. Some investors have finely-tuned skills that let them make great profits in highly volatile, choppy financial markets. So they will see a highly volatile stock as a good thing. Other investors (usually those with long-term investment goals) may want a super low volatility stock.
For a buy-and-hold investor, low volatility means there’s low risk and high predictability BUT lower returns. Conversely, a highly volatile stock is not as predictable, and its risk is higher. However, the potential for a greater reward awaits those who are willing to take a chance.
You do need your investments to have at least some volatility. Investments with no volatility do not go up or down. Hence, they have no returns and don’t make you money. If you want an investment with very low volatility that still makes money, you should consider something with low risk. For example, treasury bonds would be a good option, although very low risk means very low returns.
Simply put, different investors want different things. Short-term day traders need high volatile stocks to make a decent living. Long-term investors want low volatile stocks and long-term earnings expansion.
Since it primarily captures movement, we need to compare stock volatility with other metrics. For example, when you compare it with risk-adjusted returns, you can identify strong buy candidates. Finexy uses the Sharpe ratio in tandem with volatility to estimate a stock’s return potential compared to others with the same level of volatility.
Is Volatility Good Or Bad?
So at this point, you may be a little confused. We’ve said that a volatile stock carries risk with it. We’ve also said a stock with no volatility would never make you any money. We couldn’t even safely tell you what a good volatility rating for a stock would be.
In short: Yes, volatility is good. The point of trading stocks is to leave with more capital than you went in with. If volatility didn’t exist, then you would leave with the same amount that you put in. Actually, you would probably leave with less money due to potential brokerage fees.
Volatility Is Especially Important For Short-Term Traders
Day traders make decisions based on market changes that occur minute-to-minute or even second-to-second. For market prices to fluctuate so quickly that the difference between a profit or a loss can change in mere seconds, volatility is especially high.
Swing traders that work on day-by-day or week-by-week metrics have a little more wiggle room when dealing with volatility. However, volatility is still just as important to their bottom line as it is for day traders.
Short-term traders can especially make a decent profit if they can correctly predict the potential rise or fall of a stock. This is even true if that rise or fall only lasts mere seconds. These predictions are made in the forms of ‘calls’ and ‘puts.’ Correctly predicting multiple small swings in either direction can be much more profitable than when a long-term trader buys a stock and holds on to it for years until its value rises drastically.
Using Options To Hedge Portfolio Swings
Long-term investors can still turn a profit from volatile stocks, albeit maybe not quite as much as shorter-term traders. By buying put options (options that allow investors to sell the stock for an agreed-upon price regardless of the stock’s actual closing value), investors can mitigate the risk of market volatility.
And, even to a layperson, that should make perfect sense. As an investor, you buy a stock hoping that it performs well and rises in value. Then, as some added protection, you buy some put options stating that should the price of that stock fall within a certain period of time, you can still sell shares for the original price on your contract.
For example, you buy a stock at $100 per share. Then, you buy “insurance” (options) that states that if the stock price falls below X dollars by a certain date, you can still sell that stock for the higher value. You can even buy multiple puts. In the example of the $100 stock, you can buy puts that kick in if the price hits $95, $85, or $75. Each one is more beneficial than the next, specifically when using them to hedge against highly volatile stocks.
The Brookings Institute has a great article that discusses market volatility and liquidity.