Volatility

Volatility is a financial indicator that reflects the dispersion of returns for a security or a market index. Under most circumstances, the higher volatility is, the greater risks it implies. The term is usually calculated as a standard deviation between earning powers from the same security or market index.

On the stock exchange, the concept of volatility is generally related to wide fluctuations in any direction. For instance, if the stock market gains and falls more than one percent in the long run, it could be known as a “volatile” market. Price setting for option contracts is a subject of asset’s volatility.

Essence of Volatility

In fact, volatility is frequently classified as a certain risk associated with a variation of security’s costs. The greater volatility stipulates a broader spectrum of values. It implies that security prices are able to turn on a dime in a short run. So, in contrast, the lower volatility is, the fewer fluctuations it entails, and, as a result, the greater stability it has.

A key method to determine an asset’s variance is to estimate the daily profitability of an asset. That’s where traders use historical volatility, which takes into account price deviations from past averages over a certain period of time. This tool is a guide to what happens to the traded asset in percentage terms.

As a variance expresses the dispersion of returns over the mean, volatility can be called a criterion of this dispersion limited by the periodic interval. Therefore, there are daily, weekly, monthly, and annually reports. The last one is in widespread use.

Ways of calculation

To calculate volatility, first of all, it is necessary to determine the time period. Daily volatility is based on the following formula: (open price / close price). The result should be multiplied by 100% to get the exact percentage.

Or, let’s consider another case connected with monthly volatility of the enterprise’s assets. The closing price varies from $1 to $8. In other words, the first month value is $1, the second is $2, etc. 

In order to estimate dispersion, there are five steps that are mentioned below:

1. Identify the mean in a data array. It refers to adding all monthly rates, and dividing the given indicator by its number. So that an investor lays on $1, $2, $3, and so on. Then the resulting figure (36) is divided by the time interval, which is 8 months. Thus, the mean represents $4.5 per asset.
2. Figure out the difference between each data value and the mean. This indicator is known as deviation. Therefore, the investor makes the following calculations: $8 - $4.5 = $3.5; or $7 - $4.5 = $2.5; etc. This estimating process lasts until the initial data value of $1. Negative figures are also possible.
3. Square the obtained numbers. It will remove all negative quantities.
4. Sum up the squared deviations. The figure amounts to 42.
5. Divide the total number of deviations from the previous step by the amount of data array.

As a result, the standard deviation expresses the risk for the investor. It demonstrates how the price varies from the mean. 

The above-mentioned calculations are also shown in a table.

Types of Volatility

The ability to calculate volatility assists a market participant in determining the investment strategy, along with making a decision to buy or sell an asset.

As a rule, two types of the concept are distinguished:

1. historical volatility, i.e. the price fluctuations over a particular historical interval; 
2. implied volatility, or the market volatility assessment for the future time period.

In fact, there are many methods to monitor the volatility of an instrument. One of the most popular is the Volatility Index (or VIX), which was introduced in 1993 by the Chicago Board Options Exchange. A feature of this indicator lies in reflecting the market's expectations for the S&P 500 volatility for the next 30 days.

The VIX index can be called a large-scale indicator regarding the US market. It is also known as the “fear index” (if its values ​​are high, investors are likely to have jitters of high volatility in the coming month).

Factors influencing the concept

Actually, the volatility of investment instruments depends on the following factors:

• corporate news (disclosures, company reports, press releases, court news, etc.);
• macroeconomic statistics and events that may affect the industry as a whole (information on upcoming bills and other regulations, statistics, bank decisions on the key rate, etc.);
• national and international political events (statements by politicians, terrorist attacks, disasters, sanctions, etc.).

The aforesaid events are usually published at a certain time. In the run-up to these releases, analysts and news agencies make forecasts. Volatility of the asset is higher, in case the expectations aren’t in line with the real indicators.

Volatility in real life

According to the intensity of volatility, several groups of investment instruments come into play. For instance, futures, options, and cryptocurrencies are considered highly volatile assets, and are more prone to price spikes. Stocks and traditional currencies are less risky in this regard, but are also classified as volatile. In contrast, corporate bonds and government debts are typical instruments with low market fluctuations.

A case in study can be the cryptocurrencies that don’t possess an underlying asset, so it is almost impossible to predict their value. The rates of the most famous cryptocurrencies - bitcoin and ethereum - have changed cyclically over the past years. For example, the value of bitcoin in February 2021 exceeded $51,000, although its previous cost was only $37,000.