Develop your understanding of market volatility and learn how it can impact your trading and investing.
Changes in levels of market volatility can influence every aspect of your trading and investing. Understanding the types of market volatility can help you to navigate the markets in a way that suits you and potentially helps you achieve your financial goals.
Volatility is a term used widely in the financial markets. The textbook definition relates to the scale and speed of price moves, but the term is also used to establish overall market sentiment and levels of systematic risk.
What does market volatility mean?
Market volatility is a statistical measure of how much and how quickly the price of an asset moves over a defined period of time. The time element can be adjusted to allow traders and investors to consider volatility over long- or short-term timeframes, and a high volatility market will be associated with greater price moves that occur more frequently.
Tip: Volatility measures price fluctuations in a single market but can also describe the state of the wider financial system.
Types of market volatility
There are various types of volatility and different ways to categorise them. Price changes in a particular asset can be compared to those in other markets or in relation to a benchmark index such as the S&P 500 Index.
Price volatility
This core measure of volatility measures how far, and how quickly, price moves away from the longer term average price of that asset. This measure is represented as a percentage of the asset’s current price.
Stock volatility
Stock volatility refers to the price changes in an individual stock, as compared to a benchmark index such as the Dow Jones 30. This allows your analysis to measure a stock’s volatility against its peer group.
If the score is 1, it means that the stock’s volatility is identical to that of the benchmark. If it is higher than 1, the asset is more volatile or high beta. If it is lower, it is less volatile and low beta.
Historical volatility
Using historical volatility allows you to explore how the nature of price moves in an asset change over time. For example, comparing the 30-day historical volatility reading with the 10-year one will offer a view on the current state of a market.
Tip: Volatility indicators can be adjusted to whichever time frame suits your investment strategy.
Implied volatility
Implied volatility is a forward looking indicator and is not calculated using historical data but is instead measured by monitoring the prices of options being traded in an underlying asset. For example, if options in Tesla Inc stock, which are out of the money are getting more expensive, then options traders are pricing in the fact that the future volatility of TSLA stock is likely to increase.
In the run up to a major announcement, such as the release of a company’s earnings report, implied volatility can be expected to rise as the news is likely to result in analysts forming new opinions on the stocks value.
Tip: An increase in any volatility indicator reflects investors having increased levels of greed or fear.
How does market volatility impact the stock market?
Increased stock market volatility can cause a shift in the decision making of investors and traders and generate a herd mentality. Each individual decision to trade in or out of positions, to seize opportunities or manage risk, combine to create an aggregate change in market mood, and price levels.
Changes to volatility levels can also impact trade volumes and market liquidity – influencing how easy and cost-effective it is to trade. If an asset’s price is whipsawing, some investors will hold off booking new trades until the situation calms down. In the same way, when liquidity dries up, the wider difference between bid and offer prices can act as a catalyst for increased volatility to enter the market.
Tip: In most cases, the higher the volatility, the riskier the market is to trade.
Impact of Covid 19 on the stock market
The Covid pandemic of 2020 resulted in the highest rise in the history of the Chicago Board Options Exchange (CBOE) Volatility Index. This measure of implied volatility reached 83 units on March 16, 2020, but had been trading between 12 and 15 points prior to the pandemic.
Not only did the S&P 500 Index lose one-third of its value between February 20 and March 23, 2020, but the ride down was a historically bumpy one as well.
Impact of the 2007–2008 financial crisis
On September 29, 2008, the Dow Jones 30 Index fell from 11,143 to 10,365, over 777 points. This was the largest one day drop in value since the Dow Jones began in 1885. Less than a month later, the DJ30 rose over 936 points in one day. Unsurprisingly, such moves caused a spike in stock price volatility and the VIX index jumped from 19.58 on 11th August, 2008 to 79.13 on 20th October that same year.
The change of mood was not limited to equity markets. Most commodities recorded record volatility which was 50% higher between 2008-2009 than during other periods, but by 2010 volatility levels had returned to historical norms.
How to trade a volatile stock market?
Your approach to volatility will depend on your risk appetite, investment aims and preferred strategy.
For short-term traders, who try to predict the direction of quick and erratic price movements, volatility is often more important. Therefore, many short-term traders look out for any factors that can generate volatility.
However, one person’s opportunity is another person’s risk. A lot of investors equate volatility with risk — and with good reason. If you are investing for the long-term, the ideal situation is to have a steady incline with a minimum drawdown. Therefore, in theory, the less volatile an asset, the less likely it is to show a sudden drop in price.
Whatever your approach to risk, it is important to develop an understanding of how volatility can impact your trading psychology. Then, consider the approaches other traders use to navigate volatile markets. These include trend and momentum trading strategies, risk management and hedging.
Tip: The way that the subject of volatility is approached is one of the key differences between trading and investing.
Final thoughts
Volatility is dynamic, which means that quiet markets can become highly volatile, and vice versa. At any one time there will likely be a market that has volatility levels to suit your preferred style of trading. This makes considering which assets to trade a good starting point for any trading strategy.
Visit the eToro Academy to learn more about the pros and cons of volatility.
FAQs
- Is low volatility always a good sign to invest?
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No, low volatility can also be a predictor of a pending market correction because it signifies investors becoming complacent. It might also be the case that your strategy requires a sufficient amount of volatility to be viable.
- Are volatility and risk the same thing?
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No, volatility is related to the range in which an asset can move, while risk refers to its potential to suddenly change direction. In theory, an asset can be very volatile but display predictable patterns over time, which actually makes it less risky. Volatility is often considered a reliable measure of an asset’s risk, but there are other factors that need to be taken into account when determining risk levels.
- How can I reduce overall risk when markets are volatile?
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Scaling back on position size will reduce the overall exposure of your trades. This can be done by deciding not to use leverage or not trading until conditions are more conducive to your approach.
This information is for educational purposes only and should not be taken as investment advice, personal recommendation, or an offer of, or solicitation to, buy or sell any financial instruments.
This material has been prepared without regard to any particular investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Not all of the financial instruments and services referred to are offered by eToro and any references to past performance of a financial instrument, index, or a packaged investment product are not, and should not be taken as, a reliable indicator of future results.
eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this guide. Make sure you understand the risks involved in trading before committing any capital. Never risk more than you are prepared to lose.