What is Volatility?

What is Volatility?

The value of your assets is always changing. The price of stocks and other investments will go up and down over time, which can affect your bottom line. That’s why it’s important to track volatility. Volatility calculates an asset’s potential to rise or fall in value over time. Volatility is a key component of investing and trading. You will need to calculate volatility when trading stocks and investments to make sure you know the potential risk. Learn more about volatility and how it’s calculated to make an informed decision every time you invest.

What is Volatility?

Volatility expresses the potential range of values for a particular asset or market index. The higher the volatility, the wider the value will range over a set period of time. Volatility is expressed as a percentage with no set unit. When volatility is high, an asset’s value is likely to change dramatically over a short period. When volatility is low, the value will likely remain steady over the same period.

Volatility essentially measures how much the value of the asset changes from day to day, month to month, and year to year, also known as the variance. The statistical average represents the median change in value over a set period of time. While the variance or deviation in value, volatility measures that variance within a unit of time, which allows us to calculate the asset’s daily, weekly, monthly, or annualized volatility.

Volatility indicates how much the value is likely to increase or decrease, so you can decide if it’s a worthwhile investment. The more volatile the asset, the riskier the investment. In other words, volatility means that the value is subject to change dramatically, which increases the chances of losing money.

Historical volatility (HV) is based on an asset’s range of returns over the set period. It can be used to determine how much the value has changed over time. While HV doesn’t look toward the future, investors can still use this information to get a sense of how well the stock will perform in the future.

Implied volatility (IV) is the prediction of how wide the values will range in the future. The IV may rely on a wide range of data sources, including HV, when making predictions. It is not an exact science but can help investors calculate risk.

What is Volatility in Stocks?

Stock volatility refers to how much the value of the stock will range over a set period of time. Analysts often use the stock’s opening and closing prices as data points. Investors use stock volatility to decide if the particular stock is a worthy investment.

What is Market Volatility?

Market volatility refers to how much the value of the overall market will range over a set period. Market volatility is often highest during times of economic stress and uncertainty. Investors use market volatility to decide whether it’s a good time to invest in the market at all.

What is a Volatile Investment?

Investment volatility refers to how much the value of a type of investment will range over a period of time, such as stocks, bonds, real estate, commodities, and other forms of investment. Investors consider market volatility to inform the makeup of their portfolios.

How is Volatility Calculated?

There are several different ways to calculate an asset’s volatility.

Calculating the Variance and Standard Deviation

The easiest way to calculate volatility is to first find the variance of the asset’s value over a set period of time. The variance refers to the statistical range in values the asset has produced. Let’s take a stock’s closing prices as an example. Assume that the stock went up in price $1 every day for 10 days. It started at $10 on day 1 and ended at $20 on day 10.

First, you’ll need to find the mean of the data set. Add up all the values and divide by the number of values in the data set. In this case, the total would be:

10 + 11 + 12 + 13 + 14 + 15 + 16 + 17 + 18 + 19 + 20 = 165                 

Now, we divide the total by 10, the total number of values. That leaves us with a mean or average price of $16.5.

Now, you’ll need to calculate the difference between each value and the average price, also known as the deviation. Do this for every value in the data set. For example, 20 – 16.5 = 3.5, 19 – 16.5 = 2.5, and so on going all the way back to 10. Include negative values as well.

You should be left with the following values: 3.5, 2.5, 1.5, 0.5, -0.5, -1.5, -2.5, -3.5, -4.5, -5.5, and -6.5.

Next, you’ll need to square each deviation by multiplying it by itself. This will eliminate any negative values. You should be left with the following values: 12.25, 6.25, 2.25, 0.25, 0.25, 2.25, 6.25, 12.25, 20.25, 30.25, and 42.25.

Add them all up, and you get 135. Now, divide the sum of the squared deviants by the number of values (10). This leaves us with a variance of $13.5.

The standard deviation is the square root of the variance. In this case, that would be $3.67.

You can use the standard deviation to predict where the value is headed. When looking at the normal distribution of returns for an asset, 67% of all data returns will come within one standard deviation ($3.67). That means two-thirds of all value changes will fall within a range of $3.67. Ninety-five percent of all data returns will come within two standard deviations (2 x $3.67 = $7.34) and 99.7% of all data returns will fall within three (3 x $3.67 = $11.01).

However, most stocks don’t increase by the same value every day. We didn’t include randomly selected data in the example for the sake of simplicity. Most values are expressed on a bell curve, so the standard 67%, 95%, and 99.7% expectations won’t play out in most scenarios. But investors and analysts still use the standard deviation despite these limitations.

Calculate the Beta

You can also measure the volatility of a particular asset using its beta, which approximates the potential range in returns against the range of returns from an established benchmark, such as the S&P 500.

When using the beta method, the stock is assigned a beta value expressed as a percentage. For example, if the stock has a beta value of 1.2, it will increase 120% in price for every 100% move by the beta market. This is an easy way to calculate volatility based on what the market is doing; however, the beta should match the asset in terms of expected risk in order for the comparison to work.

Perhaps the most famous example of the beta method is the VIX Volatility Index, which was created by the Chicago Board Options Exchange. It expresses the 30-day expected volatility of the entire U.S. stock market based on real-time price reporting from the S&P 500. In many ways, it represents overall investor confidence in terms of the future of the market. When the VIX reading is high, expect a risky market.

RELATED CATEGORIES: Macro