Volatility is a part of every market out there. No matter how stable a market may seem at first sight, there will still be a small amount of volatility that will shape the future of that market. Volatility can be found in many places, from the economics of a major nation to the volatility of the crypto market on a daily basis. But let’s see what volatility exactly is and how it can shape the future of various markets.
When it comes to the financial world, volatility refers to the rapid change in the value of an asset; it could be a stock, a crypto asset, or even an NFT. It can be healthy and beneficial, giving investors a steady increase in the price of an asset. Moreover, it can be quite extreme, with high price increases and rapid price decreases.
Understanding Market Volatility
Volatility is frequently used to describe the degree of risk or unpredictability associated with large fluctuations in the value of an asset. Vulnerability increases the range of possible possibilities that a security’s value could take. As a result, the price of security might go from one extreme to the other in a matter of seconds.
Volatility has a bad connotation because investors associate it with huge drops in the price of an asset, leading to market chaos and further drops in price. However, volatility can also be bullish, giving investors a steady increase in the price of the asset that they have invested in. Whenever a market is experiencing turmoil, investors can bet on it and cause even bigger swings in price.
One of the most popular examples of this happening is the 2008 Financial Crisis. When investors were alarmed by the collapse in global markets, which in turn caused the Dow Jones Industrial Average to collapse, making it the largest 24-hour decrease at the time. Although extreme price drops like this are quite rare in the present market.
On a day-to-day basis, what markets usually experience is healthy volatility. Experienced investors take a look at the markets and assess whether it’s a good or bad investment, and they sell or buy accordingly. Some investors spend their whole lives studying the stock market to achieve this type of knowledge and make a considerable profit.
Historical Volatility
This determines how much the price of the stock has changed throughout its history. On the basis of the historical patterns it identifies, it is applied to the task of forecasting the movements of prices in the future. On the other hand, it does not offer any information about the future trend or the direction that the price of the asset will take.
Implied Volatility
This is a reference to the volatility of the asset that will provide the theoretical value of an option similar to the option’s market price if the volatility of the underlying asset is high enough. The level of implied volatility is an important determinant of the price of options. It offers a perspective on potential changes in prices in the future.
The Cboe Volatility Index (VIX)
The Cboe Volatility Index (VIX) measures the market’s predictions for relatively close S&P 500 Index price movements (SPX). Since it’s based on near-term SPX index options, it predicts monthly volatility. Volatility, or the rate at which prices fluctuate, is sometimes viewed as an indicator of market attitude, and specifically the level of anxiety among investors.
This index is far more frequently referred to by its ticker symbol (VIX). It was initially created by Cboe Global Markets. It is a significant index in the trade and finance sector since it measures market risk and investor attitudes.
The VIX seeks to assess the degree of S&P 500 price fluctuations. The greater the amount of the index’s price fluctuations, the greater its volatility, and conversely. In contrast to being a volatility index, investors may trade VIX futures, options, and ETFs to hedge or anticipate fluctuations in the index’s volatility.
Volatility can typically be evaluated using two distinct techniques. The first method relies on historical volatility and employs numerical calculations of prior prices over a given time period. On historical pricing data sets, this procedure involves calculating several statistical metrics, including mean (average), variance, and standard deviation.
The second mechanism utilized by the VIX is to imply its value based on suggested option prices. Options are derivative contracts whose prices rely on the likelihood that the present price of the commodity stock will change sufficiently to reach a certain level.
The possibility of price movements inside a given time frame is represented by the volatility factor, and option pricing methods such as the Black-Scholes model are used. These include volatility as a parameter to try and predict the price of an asset.
How To Trade VIX
Utilizing day-to-day volatility as a tradable asset has been made possible thanks to the VIX. Simple volatility exposure can be gained through the use of VIX-related features, which have formed a whole new asset category.
Because there is a strong link between stock market returns and volatility, professional investors, major investment firms, and hedge fund managers use VIX-linked instruments to protect their investments and make sure they get the best returns.
Straight purchases of the VIX are not possible, as is the case with all other indexes. Alternatively, traders may take a position in the VIX through the use of futures contracts, options contracts, or exchange-traded products that are based on the VIX.
Stock Market Volatility
The degree to which the total amount of the stock market rises and falls is a measurement of what is referred to as the stock market’s volatility. Aside from the market as a whole, the volatility of certain stocks is also an important factor.
To be more explicit, you may evaluate a stock’s volatility by analyzing the degree to which its current price deviates from its long-term standard value. The statistical measure that is most frequently utilized to characterize volatility is the standard deviation.
Whenever unpredictable factors generate instability, it might cause the stock market’s volatility to increase. For instance, whereas the main stock indexes don’t generally change by more than 1% in 24 hours, during the start of the COVID-19 outbreak, those indexes started rising and dropping by more than 5% every day.
This is in contrast to the typical lack of movement of more than 1% in a single day. No one knew what would happen, so manic buying and selling began. Moreover, there are certain stocks that are more prone to volatility than others.
Crypto Market Volatility
The majority of people who keep an eye on the crypto market are likely to accept that the instability of cryptocurrencies (Ethereum, Bitcoin, etc…) is in a category of its own. There are no indexes you can use to measure how volatile cryptocurrency prices are.
However, all it takes is a simple glance at price history graphs to see that the price levels of cryptocurrencies experience rapidly rising spikes and major drops at a faster and more severe pace when compared to the prices of assets traded on traditional markets.
(Bitcoin’s volatility since its inception. Source: CoinMarketCap)
A good number of the factors that contribute to price swings in traditional markets are also present in cryptocurrency marketplaces. Price fluctuations are driven by changes in the media as well as anticipation, and this is true for both the cryptocurrency market and the traditional market.
The impact of these factors, however, is made worse by the fact that cryptocurrency markets are a little less liquid than standard finance markets. This is because there aren’t enough investment firms and big trading companies in the cryptocurrency markets to keep things in balance.
Since these factors run off of one another, the pairing of heightened volatility and low liquidity can be a risky one for investors. Aside from Bitcoin (BTC), the majority of other cryptocurrencies similarly do not have futures markets that are well-established and actively used.
Cryptocurrency prices, which are subject to the influence of day investors and speculators, often display the same type of beneficial volatility that is seen in traditional markets. It is not yet known whether or not the volatility of cryptocurrencies will ultimately resemble the volatility tendencies that are found in traditional markets.
However, because this asset class is still expanding and developing at a rapid rate, it is quite likely that it will continue to display excessive volatility on a consistent basis until it reaches full development in the future.
What Leads To Volatility?
The following is a list of some of the primary factors that contribute to the volatile nature of a certain asset:
Political/Economical Factors
To begin, governments contribute to the process of managing industries and have the ability to influence economies through the decisions they make concerning trade deals, regulations, and policies. The actions of investors can be influenced by anything from rallies to elections, which then in turn can have an impact on stock prices.
The Industry
Certain changes have the potential to produce turbulence within a particular industry or sector. For instance, in the oil industry, a significant weather event that occurs in an essential oil-producing region might lead to a rise in the price of oil. As a consequence of this, the share prices of firms that are associated with oil transportation may increase since it is anticipated that they will profit.
In a similar manner, increased government intervention in a particular sector may lead to a decline in share prices due to higher compliance and labor costs, both of which may have an impact on the growth of potential income.
The Most Volatile Sectors
Certain stock markets have a tendency to behave in a certain way. Some of them have an appropriate level of volatility, which provides their investors with an enjoyable experience. Nevertheless, certain stock markets have a tendency to move up and down at a rate that is inconsistent. Let’s take a look at some of the markets that are known for their extreme volatility.
The Technology Sector
The technology industry encompasses a vast array of different products and services. On the retail side, it includes items such as desktop PCs, phones, TVs, and various home appliances. This industry delivers equipment, computing services, and logistics systems to organizations all over the world. Apple, Google, and Microsoft are just a few of the well-known companies that work in this industry.
The Energy Sector
Petrol, natural gas, and coal extraction are examples of businesses that fall under this category, as are renewable energy sources such as biofuels, geothermal, hydropower, tidal energy, solar panels, and wind turbines. The decade of the 2010s saw the biggest standard deviation in this industry, which peaked at 20.3%.
The Financial Sector
The majority of this industry is made up of financial institutions such as banks, investment companies, insurers, money managers, stock exchanges, and currency exchanges. During the global economic crisis of 2007–2008 and the Great Recession that followed, this industry was subject to extremely volatile market conditions.
Why Is Volatility Important?
The present market conditions might be made clearer if you have a basic understanding of how volatility behaves. You should consider the risks associated with each investment before building a stock portfolio that meets your long-term growth ambitions while also being in line with your tolerance for risk.
However, it is essential to keep in mind that risks and volatility are not quite the same. Volatility and risks are strongly intertwined in the minds of professional investors who approach each trading day with the goal of “buying low and selling high.” Volatility is an additional factor to consider for investors who may soon be forced to sell their equities, such as those who are getting close to the age of retirement.
The day-to-day fluctuations of equities, on the other hand, are of virtually zero significance to lengthy traders who often hang onto their holdings for a number of decades. Whenever you allow your assets to grow for a very long time, volatility becomes nothing more than background noise.
Lengthy investing does contain dangers, but these dangers are not associated with volatility but rather with the possibility of being incorrect about the future potential of a business or spending an excessive price for that growth. Nevertheless, investors should be well-versed in the notion of stock market volatility because it is an essential one.
Volatility alone is not a negative thing to have, since market corrections can occasionally create entryways from which investors might benefit. Any market correction can allow an investor with capital to purchase at a lower price. Negative market volatility gives investors that anticipate markets may perform well during the long haul a chance to buy more shares at cheaper prices.
It is normal to feel anxious whenever there is a period of volatility in the market. The sight of significant or even small losses recorded on paper can be unsettling. However, in the end, you need to keep in mind that the instability of the marketplace is a normal and expected component of investing and that the businesses in which you invest will react to a crisis.
Frequently Asked Questions (FAQ)
What Causes The Market To Be Volatile?
Anxiety, in one form or another, is typically the root cause of market volatility. This could be the result of shifts in interest rates as well as developments on a regional or international scale. Pricing in the market is mostly determined by predictions for the future, yet when the future appears less foreseeable, market volatility increases.
Is A Volatile Market Good?
Markets are constantly volatile and sometimes tremendously turbulent. Some traders hesitate until prices fall to purchase. Excessive market volatility is psychologically uncomfortable, particularly when stocks are declining, despite being cheaper.
What Is Market Risk?
Markets are inherently volatile due to the numerous factors that cause prices to fluctuate continually. Volatility in the market might pose a threat if frantic selling results in a loss. Whereas, market risk is the probability of not receiving the predicted market performance.
Takeaways
- When it comes to the financial world, volatility refers to the rapid change in the value of an asset; it could be a stock, a crypto asset, or even an NFT.
- However, volatility can also be bullish, giving investors a steady increase in the price of the asset that they have invested in.
- The Cboe Volatility Index (VIX) measures the market’s predictions for relatively close S&P 500 Index price movements.
- The degree to which the total amount of the stock market rises and falls is a measurement of what is referred to as the stock market’s volatility.
- The present market conditions might be made clearer if you have a basic understanding of how volatility works.
- A good number of the factors that contribute to price swings in traditional markets are also present in cryptocurrency marketplaces.
- Whenever unpredictable factors generate instability, it might cause the stock market’s volatility to increase.
- You should consider the risks associated with each investment before building a stock portfolio that meets your long-term growth ambitions.
- Excessive market volatility is psychologically uncomfortable, particularly when stocks are decreasing, despite being cheaper.
