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The primary fear for investors when engaging in the stock market is the fear of losing money. This risk of losing money in the market is associated with price fluctuations that might be too hard to comprehend at first. It is due to this lack of knowledge that investors often tag the market as a gambling arena.
The price of a stock is bound to move upwards or downwards – this unpredictable movement due to inherent stock market volatility is what investors need to use to their advantage to emerge victorious.
Let’s discuss this concept of volatility in detail and why every investor must know about it.
What is volatility?
Volatility measures the magnitude of stock price fluctuations. This sudden price swing could be witnessed in the entire stock market overall or in the value of just a few selected stocks.
Now, there could be several reasons for this price volatility in the stock market. However, the major reason is investor sentiment which eventually also leads to a change in the demand and supply graph of a stock. Other factors that cause volatility risk are political factors, economic factors, performance of the company, etc.
A recent example of a global event that disrupted the stock market is the conflict between Russia and Ukraine which significantly impacted oil and energy sector stocks, which mpacted the stock market of various countries.
However, volatility isn’t always market-wide and can relate to the individual performance of a company. For example, mergers and acquisitions or strong quarterly earnings reports of a company can lead to a sharp change in the price of its stock.
As an investor, you must remember that nominal price changes in the value of a stock are very normal. Markets become volatile when market fluctuations take big swings, and there is a rapid up-and-down movement in the value of securities. The bigger the deviation, the higher the volatility.
Types of volatility
There are two primary types of volatility, i.e. historical volatility and implied volatility. As you might have guessed, historical volatility focuses on past price volatility data, whereas implied volatility focuses on upcoming price changes. Both these concepts have been explained in detail further.
1. Historical volatility
Historical volatility is also known as statistical volatility, it is a study of the past price fluctuation of an asset over a specified period. Investors study historical volatility to predict future fluctuations in price movement. For the purpose of monetising volatility through this method, investors use the standard deviation method. By using this method, they can gauge the extent to which the price of a security has fluctuated from its average price.
2. Implied volatility
Implied volatility also known as projected volatility, is used by investors to determine the price fluctuations of an asset in the future. It is a forward-looking calculation; you should not confuse it with historical volatility.
While both are used to make assumptions about the price of an asset in future, this type is more widely used by investors. Like common practice, you can refer to a volatility index or other derivative instruments, such as S&P 500, to determine the upcoming marketing volatility.
Ways to measure volatility
Volatility, in a way, is the essence of the stock market. When markets are volatile, the valuations become more attractive. This increases the risk of investment, but the returns can be equally rewarding. It is important to learn how to measure volatility and use it to one’s advantage.
The two popular ways to measure volatility have been explained below:
Beta
The beta is used to determine the volatility of a single asset against a specific index, which is also known as the beta index. It leverages the data of historical volatility to determine and measure the volatility of a particular stock.
Investors commonly use the S&P 500 to compare deviations. If a stock has a beta value of 1.3, it means its value has moved 130% as compared to its index. Similarly, if the beta value is only 0.75, then the stock price has fluctuated by only 75% compared to the price fluctuation of the index.
A beta value of less than 1 indicates low sensitivity to market changes, equal to 1 indicates no sensitivity, and more than 1 indicates high sensitivity.
VIX
This Volatility Index (VIX) was created by the Chicago Board Options Exchange in 1993 and is also popularly known as the ‘fear index.’ Investors use it frequently to measure the expected volatility of the U.S. stock market for the next 30 days based on S&P 500 index options.
If the reading on VIX is high, it generally implies more risk, and the options become more expensive. In such circumstances, investors allocate a bigger portion of their capital towards fixed-income financial instruments such as bonds. Hence, when markets crash, VIX shoots up, indicating higher stock market volatility and the fearful sentiment of the investors.
How do stock prices get influenced due to volatility?
Volatility is an inevitable feature of the stock market. The higher volatility of an asset indicates higher levels of risk. During these times investors become more prone to impulsive selling or making dramatic changes in their portfolios. However, it is exactly during these times of market fluctuations that you must exercise some patience and avoid such impulsive actions.
A more volatile market indicates bigger swings in the price of stocks across different sectors, whereas a lesser volatile market shows smaller swings in the price change.
How to manage volatility in investment?
Your market strategies should heavily depend on your style of investing. Before opening an account for investing in US stocks, here are some tips that you should know on how to manage the volatility of the stock market:
- For long-term investors, it is best to ignore short-term price fluctuations and remain on course. Exercising patience during this time can help to sail through the temporary volatility because, in the long run, markets almost always tend to rise.
- Adding some diversification lowers the risk of your portfolio. Investing in a wide variety of assets or sectors helps balance out the risk of more volatile assets with other assets that derive a fixed income.
However, even with a diversified portfolio, there would always be a certain level of volatility attached to it, and there will always be some degree of risk associated.
- Depending on your financial goals, you can invest in stocks when the trend is bearish and wait for it to reverse. This is called buying the dip, and investors often use this strategy to capitalise on the fluctuating market.
- If the markets are volatile and you have a short-term goal on your mind, you can choose a less volatile alternative to make profits. This will prevent you from getting anxious over market fluctuations and lowers the investment risk.
