What Is Volatility?
Volatility is a term which every trader will have come across at some point. But what is volatility? And what are its implications on trading? In this article, we will examine the answer to these questions, explain the different types of volatility, introduce some methods of measuring it and more!
Table of Contents
What Is Volatility?
So, what is volatility? Volatility is a way of measuring price variability. More specifically, it is the measurement of an asset's price distribution around the mean average over a period of time. In other words, it measures how far the price of an asset moves either side of the average price.
An asset with high volatility will have prices which are spread widely from the mean, whereas the prices of an asset with lower volatility will be closer to the mean.
Assets with high volatility are considered to be riskier. However, the presence of a certain amount of volatility can be a welcome factor for traders who attempt to profit from the swings in both directions of price.
Historical Volatility vs. Implied Volatility
Now we have an answer to the question 'what is volatility', let's take a look at the difference between historical volatility and implied volatility.
Historical volatility, sometimes referred to as statistical or realised volatility, as the name implies, looks backwards to measure the price dispersion over a given period of time.
Implied volatility, on the other hand, looks at the likelihood of future changes in the price of an asset, which can be used to estimate the future volatility.
There are many measurements and indicators which are used to deduce the value of either historical or implied volatility. In the following sections, we will look some of the most well-known methods of measuring volatility.
Measuring Volatility
Standard Deviation Volatility Indicator
When it comes to historical market volatility, standard deviation is one of the most common methods of measurement. For anyone who has not studied statistics, the calculation of standard deviation, which is the square root of variance, can be challenging.
Fortunately, with advances in technology, traders don't need to worry about calculating an asset's standard deviation themselves. With MetaTrader 5, the standard deviation volatility indicator comes as part of the standard package and can be easily added to your price chart.
As seen in the image above, it can be added to any price chart by clicking on the 'Indicator' drop down at the top of the screen in your MetaTrader 5 trading platform.
If prices are selected randomly from a normal distribution curve, about 99.7% of all values will fall within 3 standard deviations of the mean, 95% within 2 standard deviations and 68% within 1 standard deviation.
Many traders choose to use a standard deviation volatility indicator as prices for most asset prices tend to follow a normal distribution.
The important thing to remember is that an asset with a high standard deviation will have a high historical market volatility.
Looking at our GBPJPY chart above, we can see that there was one occassion in the chosen timeframe where volatility was significantly higher than normal.
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The Black Scholes Model
The Black Scholes model is a mathematical model used to price option contracts. The variables involved are as follows:
- Underlying asset's current price
- The strike price
- Time until expiration of the option
- The risk-free interest rate
- Underlying asset's volatility
As you can see, one of the variables used in the calculation of the options price is volatility. As with any equation, if all the other variables are known, the Black & Scholes equation can be rearranged to work out an asset's volatility.
The resulting value is normally referred to as the "implied volatility", since it is the volatility implied by the equation and the current market variables.
There are, however, several drawbacks to using this model. The model assumes that the asset's volatility is constant, when in reality, volatility constantly fluctuates along with supply and demand.
The model is also limited in use to European-style options and not American-style options. European options can only be exercised on their last day, whereas American options can be exercised at any time between the contract starting and ending.
CBOE Volatility Index
The CBOE Volatility Index (VIX), sometimes referred to as the fear index, is a measure of anticipated volatility in the stock market. Its figures are derived from the S&P 500 index options.
The calculation for the VIX is too complex to dissect in this article, however, the more mathematically gifted of you may be interested in reading CBOE VIX's 'White Paper' - which includes a step by step breakdown of the calculation used.
Below is a table showing the average monthly closing value of the VIX for the first nine months of 2021 vs the same months in 2020.
Source: Monthly Average of Daily Closing Prices of CBOE Volatility Index (VIX).
An index value of below 12 implies low volatility in the market, whilst above 20 demonstrates a high level of volatility. Any value between 12 and 20 is considered to be normal.
Perhaps unsurprisingly, given the coronavirus pandemic, we can see that the VIX was significantly higher than the normal range for many of the 2020 months. In 2021, with the exception of January and February, the VIX is lower and has spent most of the time within the normal range.
What Causes Volatility?
There are many different causes of volatility in the financial markets and, sometimes, the explanation for it is not clear at all.
The common denominator is people and how they react to different news, economic events and general happenings in the financial markets. Anytime there is uncertainty you should expect the markets to become more volatile.
Bearing this in mind, there are certain events where you can predict there will be higher volatility than usual and, depending on your trading style, you can choose to either to trade or not to trade the market during these times.
For example, in the lead up to and immediately after important economic announcements the markets tend to become more volatile. Therefore, it is important to keep track of when such announcements are due to be made. This is something which you can easily incorporate into your trading with our economic calendar.
What Does Volatility Mean For Traders and Investors?
We mentioned above that the existence of high market volatility is usually associated with a greater level of risk. However, traders and investors will all have differing opinions on volatility depending on what type of trader they are and their appetite for risk.
For example, a more traditional investor who plans to purchase stock in a company to hold on to for an extended period of time, will most likely be looking to avoid anything with a high level of volatility.
This type of investor will want to find a security which they can purchase and then leave to hopefully gain gradually in value without constantly checking the markets. Therefore, the presence of volatility and its associated risk will be off putting.
On the other hand, lots of short-term traders, such as scalpers, thrive off high volatility, which may actually be a necessary part of their trading strategies. These types of traders attempt to profit from both the rising and falling prices of a financial instrument.
For these types of traders, accepting the higher risk is worth the potential profit making opportunities which volatility brings. However, unlike our longer term investor, trading under these conditions requires a trader to be more present at their trading terminal.
Final Thoughts
You should now have an answer to the question 'what is volatility', understand the different types of volatility which exist, the effect it has on traders and some of the ways it can be measured.
It is important that traders who choose to enter the market during periods of high volatility exercise sound risk management, such as always remembering to set a take profit and a stop loss.
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.
