Stock Market Volatility: What it is & How to Measure it The Motley Fool

Volatility is a statistical measure of dispersion around the average of any random variable such as market parameters etc. Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master’s in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem.

But diversifying your portfolio can help you mitigate the risks over time. And if you’re interested in taking things a step further, learn about the options market. There are options strategies designed for pretty much any market condition—up, down, and sideways—as well as strategies designed to protect your portfolio when the market declines. Beta measures a security’s volatility relative to that of the broader market.

The Cboe Volatility Index (VIX) detects market volatility and measures investor risk, by calculating the implied volatility (IV) in the prices of a basket of put and call options on the S&P 500 Index. A high VIX reading marks periods of higher stock market volatility, while low readings mark periods of lower volatility. Generally speaking, when the VIX rises, the S&P 500 drops, which typically signals a good time to buy stocks.

What Is Market Volatility—And How Should You Manage It?

A beta of 0 indicates that the underlying security has no market-related volatility. However, there are low or even negative beta assets that have substantial volatility that is uncorrelated to the stock market. Above all, volatility will impact investing strategy as in general rational investors don’t like too much swing (ups and downs) in their investment returns. But extent of this impact will depend on the investment horizon, composition of the current portfolio and investor’s risk tolerance. These figures can be difficult to understand, so if you use them, it is important to know what they mean.

The VIX index calculation uses SPX index option prices to reflect how much SPX is expected to move over a given period of time. If people are feeling fearful or uncertain about the market, then options prices may move higher, as will the VIX index. When investors are complacent about market pricing and uncertainty is low, VIX can decline. Volatility describes an asset’s potential to rise or fall from its current price. It is expressed as a percentage and measures the variability of returns – money made or lost – over a period of time.

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Obviously, the opposite is true, in that if the ups are lower than downs, in the long run, the stock price is decreasing. Investors expecting the market to be bullish may choose funds exhibiting high betas, which increases the investors’ chances of beating the market. If an investor expects the market to be bearish in the near future, the funds with betas less than one are a good choice because they would be expected to decline less in value than the index. For example, if a fund had a beta of 0.5, and the S&P 500 declined by 6%, the fund would be expected to decline only 3%.

As an indicator of uncertainty, volatility can be triggered by all manner of events. An impending court decision, a news release from a company, an election, a weather system, or even a tweet can all usher in a period of market volatility. Any abrupt change in value for any underlying asset — or even a potential change — will inject a measure of volatility into the connected markets. Market volatility is measured by finding the standard deviation of price changes over a period of time. The statistical concept of a standard deviation allows you to see how much something differs from an average value. One measure of the relative volatility of a particular stock to the market is its beta (β).

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An investor could “time” the market, i.e. buy the stock when the price is low and sell when the price high. For most investors, timing the market is difficult to achieve on a consistent basis. Long-term investing still involves risks, but those risks are related to being wrong about a company’s growth prospects or paying too high a price for that growth — not volatility.

A beta of 1 means the security has a volatility that mirrors the degree and direction of the market as a whole. If the S&P 500 takes a sharp dip, the stock in question is likely to follow suit and fall by a similar amount. Also, market volatility implies that stocks return trends are cyclical in nature. Thus, stocks that go up will go down and everything that will go down will go up. The issue is then transferred to that of what level the ups and downs occur. If the ups are higher than the downs, then in the long term, the stock price is increasing.

However, the necessary information can also be obtained by gathering the monthly closing price of the investment asset, typically found through various sources, and then manually calculating investment performance. The VIX recorded the three biggest volatility spikes in 1987, 2008 and 2020 where the negative feedback loop and reduced investor holdings caused a bear market each time. Unfortunately, with a highly volatile stock, it could also go much lower for a long time before it goes up again. And there’s always the potential for unpredictable volatility events like the 1987 stock market crash, when the Dow Jones Industrial Average plummeted by 22.6% in a single day. That said, the implied volatility for the average stock is around 15%.

Standard Deviation

Access and download collection of free Templates to help power your productivity and performance. And more importantly, understanding volatility can inform the decisions you make about when, where, and how to invest. Casual market watchers are probably most familiar with that last method, which is used by the Chicago Board Options Exchange’s Volatility Index, commonly referred to as the VIX. In September 2019, JPMorgan Chase determined the effect of US President Donald Trump’s tweets, and called it the Volfefe index combining volatility and the covfefe meme.

Investors who understand and utilize volatility information may be better able to select stocks in their comfort level and to acquire and dispose of them more effectively. For instance, a market correction can provide an opportunity for an investor to buy a security at a lower price. On the other hand, if the shares of the security rise quickly, this may be a good time for an investor to sell and use the proceeds to invest in other things. Trading volatility, however, is a complex undertaking and can be quite risky. It requires an intimate knowledge of how volatility varies over time and what it’s unique characteristics are. Investors are more likely to benefit from an understanding of volatility in determining whether a stock can meet their objectives and how best to acquire it.

Tracking the Market’s Volatility

But for long-term investors who tend to hold stocks for many years, the day-to-day movements of those stocks hardly matters at all. Volatility is just noise when you allow your investments to compound long into the future. Technical analysis focuses on market action — specifically, volume and price. When considering which stocks to buy or sell, you should use the approach that you’re most comfortable with. A fund with a beta very close to one means the fund’s performance closely matches the index or benchmark. A beta greater than one indicates greater volatility than the overall market, and a beta less than one indicates less volatility than the benchmark.

Unfortunately, there are three main reasons why investment performance data may not be normally distributed. First, investment performance is typically skewed, which means that return distributions are typically asymmetrical. As a result, investors tend to experience https://1investing.in/ abnormally high and low periods of performance. Second, investment performance typically exhibits a property known as kurtosis, which means that investment performance exhibits an abnormally large number of positive and/or negative periods of performance.

Or else the trader can construct a bear put spread by buying the $90 put at $11.40 and selling or writing the $80 put at $6.75 (note that the bid-ask for the June $80 put is $6.75 / $7.15), for a net cost of $4.65. When looking at the broad stock market, there are various ways to measure the average volatility. When looking at beta, since the S&P 500 index has a reference beta of 1, then void check meaning 1 is also the average volatility of the market. A stop-loss order is another tool commonly employed to limit the maximum drawdown. In this case, the stock or other investment is automatically sold when the price falls to a preset level. Price gaps may prevent a stop-loss order from working in a timely way, and the sale price might still be executed below the preset stop-loss price.

Most typically, extreme movements do not appear ‘out of nowhere’; they are presaged by larger movements than usual. Whether such large movements have the same direction, or the opposite, is more difficult to say. And an increase in volatility does not always presage a further increase—the volatility may simply go back down again. Since observed price changes do not follow Gaussian distributions, others such as the Lévy distribution are often used.[1] These can capture attributes such as “fat tails”.

Bullish traders bid up prices on a good news day, while bearish traders and short-sellers drive prices down on bad news. Volatility is a statistical measure of the dispersion of data around its mean over a certain period of time. It’s calculated as the standard deviation multiplied by the square root of the number of periods of time, T. In finance, it represents this dispersion of market prices, on an annualized basis.

The higher level of volatility that comes with bear markets can directly impact portfolios while adding stress to investors, as they watch the value of their portfolios plummet. This often spurs investors to rebalance their portfolio weighting between stocks and bonds, by buying more stocks, as prices fall. In this way, market volatility offers a silver lining to investors, who capitalize on the situation. Besides swings in asset prices, stock market volatility also represents the riskiness of a stock or index.

• Traders who are bearish on the stock could buy a $90 put (i.e., strike price of $90) on the stock expiring in June 2016.
• It provides a forward-looking aspect on possible future price fluctuations.
• A high VIX reading marks periods of higher stock market volatility, while low readings mark periods of lower volatility.

The material contained herein is intended as a general market and/or economic commentary and is not intended to constitute financial or investment advice. Any views or opinions expressed herein are solely those of the speakers and do not reflect the views of and opinions of JPMorgan Chase. This information in no way constitutes JPMorgan Chase research and should not be treated as such. Further, the views expressed herein may differ from that contained in JPMorgan Chase research reports. The information herein has been obtained from sources deemed to be reliable, but JPMorgan Chase makes no representation or warranty as to its accuracy or completeness.

Three common approaches are beta, implied volatility, and the Cboe Volatility Index (VIX). To find implied volatility values, you may have to look specifically at options data. It’s important to note, though, that volatility and risk are not the same thing. For stock traders who look to buy low and sell high every trading day, volatility and risk are deeply intertwined. Volatility also matters for those who may need to sell their stocks soon, such as those close to retirement.