Market Volatility and What it Means For Traders
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Traders and investors often come across the term ‘market volatility’. While it is commonly used to refer to the price variability of assets, it is not always clear how important the impact of volatility is on trading. That’s why we chose to explore the concept in this article and cover the different aspects of volatility in the financial markets.
Hence, what exactly is market volatility? First, it is a measure of price fluctuations and irregularities. Indeed, an asset price movement around the average over a certain period of time gives insight into how volatile the asset is. Consequently, a highly volatile resource is one which prices spread away from the average. Whereas a low volatility resource will have prices that range closer to the mean.
Evidently, assets with high volatility are often considered risky investments. However, it can also be an opportunity to make profits. Traders who don’t mind the increased risk may try to leverage the price variations.
Causes of Volatility
There are various reasons and situations that can lead to market volatility or have a tangible impact on the prices of an asset. Usually, the underlying causes can be traced, but sometimes they are a little less obvious to determine. The common and pivotal point is always people’s reaction to a certain event. Therefore, any type of uncertainty or destabilization of a status quo can be reflected in the financial market.
Some scheduled and repetitive events can be monitored and according to their outcome traders can predict the chance of higher volatility. Many traders create an economic calendar to keep in sight important dates and announcements. Accordingly, and depending on your trading style, you may choose to trade or not to trade during these times. Here are some common causes of volatility:
- Political events, conflicts, or tensions
- Socio-economic announcements and new policies
- Natural disasters that impact the flow of resources
- Reputation crisis and public relation issues
- Events in foreign markets that influence overseas business relationships
To Leverage, or Not to Leverage Volatility
Indeed, higher levels of market volatility indicate greater risk for traders and investors. However, each trading style considers volatility in a different way. A trader’s appetite for risk and capacity to take in possible losses has a great impact on decision-making in high volatility situations. Some types of investors prefer long-term stable investments. This kind of purchase does not fit well with volatility and embracing risk. On the other hand, some short-term traders actually prefer volatile markets. They leverage these high-risk environments as they find opportunities in price changes. Often the trading strategy such traders use requires assets with turbulent price fluctuations. Therefore short-term traders can potentially benefit from the profitable opportunities that volatility brings.
Types of Volatility and How to Measure it
There are two main types of identified volatility in trading. First, Historical Volatility, which is often referred to as statistical volatility, considers previous price variation patterns over a certain period of time. Then there is Implied Volatility which looks at the potential for future fluctuations and estimates the upcoming price swings of an asset. Consequently, there are many indicators used and methods of measurement to deduce the value of either type of volatility. Here are three of the most common ones:
A very popular measurement for historical market volatility is the standard deviation. While the statistical equation can be a little intimidating, technology has mainly replaced the need for a manual calculation. Indeed, the MetaTrader 5 trading platform includes this indicator. Accordingly, traders need to keep in mind that assets with a high standard deviation have a history of high volatility.
The CBOE Volatility Index
Often referred to as the Fear Index, the CBOE Volatility Index (VIX) is a measure of anticipated volatility in the stock market. In fact, the VIX calculation is quite complex. An index value below 12 implies low volatility, values between 12 and 20 are normal, while anything above 20 means extreme volatility. A recent example is the Covid-19 pandemic, which led to increased volatility in the markets due to lockdowns and fear.
The Black Scholes Model
This measurement is used to price options contracts. Indeed, the Black Scholes model is a mathematical model which includes the following variables:
- Underlying asset’s current price
- The strike price
- Time until the expiration of the option
- The risk-free interest rate
- Underlying asset’s volatility
These variables can be rearranged in the equation to determine the value of either one of them according to which ones are known. For volatility, the resulting value is dubbed Implied Volatility. This is the trickiest of all the models as it assumes assets are in a constant state of volatility. In addition, it is also restricted to European-style options.
Now that we covered the basics of what market volatility is and its impact on prices, as a trader you should be more aware of the risk while trading. Therefore include volatility in your planning and take it into consideration when investing. Our recommendation is to always implement solid risk management techniques, especially in periods of instability.