Volatility – Meaning, Calculation, Importance and Types

The concept of volatility is used to measure the magnitude of price movements of a security. One way to determine volatility is by calculating the standard deviation of the annualised returns from security over a given period. 

Let’s learn more about volatility and how to calculate it. 

What is volatility?

Volatility is a statistical measure used to calculate the dispersion of returns (i.e. the spread of returns around a mean value) for a particular security or market index. It is often measured using the variance of the returns over a given period or the standard deviation of the returns for a given market index or security. The risk factor of a security increases with volatility.

A market is considered volatile when it rises and falls more than 1% over a given period. In simpler terms, volatility is a measure of the extent to which the value of an index or the price of a security tends to make large moves around a central value. 

Apart from this, the volatility of an asset is considered a key factor when pricing an options contract related to that asset. It is used in the option pricing formula to measure the variations in the returns from underlying assets. It helps estimate the price fluctuations that can occur over a short time period.

• Volatility is a statistical measure of the dispersion of returns, representing how much the price of asset swings around the mean price.
• The price of volatile assets is expected to be less predictable, which makes them riskier.
• Volatility acts as an important variable for investors to calculate options prices.

Why is volatility important?

Returns earned on traded securities are highly sensitive to external factors and fluctuate frequently. A security is considered to have high volatility if its price fluctuates rapidly over a short time period. On the other hand, it is considered to have low volatility if its prices fluctuate less frequently or over a longer period of time.

Since volatility considers price movements, it also indicates the risk associated with a security. The higher the volatility, the riskier the security, and vice versa. This is because rapid price fluctuations cause more uncertainty. Though volatility poses investment risks, if properly leveraged, it can generate good returns. 

Investors can use data from volatile markets to align their investment portfolios. They can also use volatility as a basis to short a stock. Ultimately, if investors have strategies to capitalise on the situation, a volatile market presents ample opportunities to get significant returns.

How is market volatility measured?

Here are two key methods of measuring market volatility:

• Beta

One way to measure the volatility of a security with respect to its market is to simply use its beta (β). The beta of a security is an approximate measure of the volatility of that security’s returns as compared with those of an appropriate reference benchmark. 

• VIX

You can also measure market volatility through the volatility index (VIX). The VIX aims to act as a rough measure of the US stock market’s volatility across 30 days. The higher the VIX value, the riskier a market is.

Types of volatility

Listed below are the two primary types of volatility:

1. Implied volatility

Implied volatility is a measure that allows traders to estimate the future volatility of a market. It is heavily used by options traders. 

Being based on the price of an option, implied volatility represents what options traders expect from the future, as opposed to historical volatility. Implied volatility is also called ‘projected volatility’.

2. Historical volatility

As the name suggests, historical volatility is derived using the actual past prices of a security over a certain period of time.

How to calculate volatility?

The statistical concept of standard deviation is used for calculating volatility. The formula to calculate volatility is:

V = σ  x √T

Where V is the volatility over a given period,

σ is the standard deviation of the returns, and 

T represents the number of periods in the time horizon

In conclusion

The volatility of a market index or security indicates the degree to which its value or price fluctuates from the mean. If a security or an index is highly volatile, it shows that its value makes relatively large moves up and down, thus making it relatively riskier. On the flip side, if there is low volatility, it implies that the performance of the security or index is relatively stable. Investors must analyse the volatility associated with their investment to ensure they invest in assets that fit their risk appetite. 

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