Meaning, Measures, and Ways of Management
When the stock market rises or falls by more than a certain percentage, we often hear the term “stock market volatility”. But what exactly does this term mean?
Does it refer to a state where we only see a consequential fall in stocks? We will address these confusions about stock market volatility in this article.
Meaning of Stock Market Volatility
In simple terms, the statistical measure of the range of potential investment outcomes, often referred to as dispersion for a given security or market index, is volatility in the market.
It depicts swings in both directions in the market; any rise or fall above 1% over a protracted period in the market shows that the market is volatile. This volatility becomes a determining factor for the pricing contract of the asset.
It often addresses the amount of uncertainty involved in the size of changes in the concerned security’s value. The higher the volatility, the chances of the difference in the security price in a brief period.
The price change may include an increase or decrease, but the fluctuations are dramatic. Whereas if the volatility tends to be lower in the market, the security price change trends tend to remain more stable. There are no significant changes in a short period.
How does market volatility affect our investing patterns, and to what extent do they affect our investment?
Stock Market Volatility Trends
2020 has been an exciting year for the stock market. Investors have seemed demented when it comes to analyzing the market during this period of extreme volatility.
There has been significant activity in market volatility this year. This is due to various factors, including prolonged lockdowns in several parts of the world. This was a key factor behind the economic recession that is taking place in many parts of the world.
A high uncertainty exists in predicting government policies. Particularly on their plans to revive the economy.
Even the U.S. election process has also left a significant impact on the market. In such situations, there lies a question of what investors should do to cope with this situation. Are there any existing strategies to deal with this situation?
There have been several types of research to study the relationship between stock market volatility and market performance. In 2011 Crestmont Research studied this historical relationship. They used the average range of the day to explore the volatility of the S&P 500.
Their research depicted that the higher the market volatility is, the probability of the market decline increases. Whereas comparatively lesser volatility pushes the market in an upward direction. Investors use this data to analyze the market trends in long-term stock market volatility. Then use this information by aligning it with their portfolios and expected returns from the market.
For example, If the average daily range of the S&P 500 is low, where the volatility ranges between 0-1%, the odds favor investors.
They are expecting to enjoy both monthly and annual gains on their existing investment. When the average daily range of the S&P 500s volatility ranges from 1.8-2.6%, investors expect losses.
The losses can range up to 0.8% per month to 5.1% annually. Similarly, the risk and effect of volatility remain mostly consistent across the spectrum.
So in this situation, how concerned should investors be about volatility? Well, let’s say not much because volatility is a part of the market.
We have seen a significant drawdown in March 2020, where all the major indices went down by about 30%. This is a perfect example of extreme volatility.
Investors should remain calm and focus on long-term goals. This approach is better than getting wrapped up in volatility during such a short period of time.
The reason behind this suggestion lies in several types of research done on the trends of the market. An overview of the stock market and volatility in all these researches suggests that stock market volatility is expected.
Still, at the same time, the market tends to rebound from any such drawdown and usually in the same financial year. This gives the confidence to stick to the long-term goals irrespective of the market’s current situation.
Factors of Stock Market Volatility
Several factors affect market volatility. This includes policies related to tax and interests on national and regional levels. Changes in inflation trends can also affect the long term stock market trends and volatility.
Measurement of Volatility
Let us assume there are closing prices for the monthly stock of $2 to $20. For example, it is $2 for the first month; for the second month, it is $4. To calculate variance, we follow five steps:-
- We find the mean of the data set. This includes adding each value and then dividing by the number of values. For example, $2 + $4 + $6……..$20 and then divide it by ten because we have ten numbers in our set. This provides us the average price. This gives us an average price of $10.
- Calculate the difference between the respective data value & the given mean. This is called the deviation. For example , we take $20 – $10 = $10 , then $18 – $10 = $8 and this will continue till the first value.
- Then, these deviations are squared to eliminate negative values.
- These squared deviations are added together.
- This sum of squared deviations is then divided by the number of data.
This helps to measure the risk and allows the trader to understand how far the price can deviate from the average price range.
Other Methods of Measuring Stock Market Volatility
Some other measures of volatility are its β. Beta refers to approximating the entire volatility of the security return against the returns of the setup’s benchmark.
For example, a stock with a β value of 1.2 has moved by 120% for every 100% move. Conversely, a stock with a beta of just 0.7, has moved only 70% for every move of 100 percent in the benchmark’s underlying index.
The Volatility index can also measure market volatility. The Chicago Board Options Exchange created this method to control the 30-day expected volatility of the U.S. stock market derived from real-time quote prices of S&P 500 call and put options.
The higher the reading of VIX, the more is the risk in the market. It detects the risk of the investor. A high reading for VIX marks specific periods indicating higher volatility in the stock market. On the other hand, low readings feature mark periods featuring lower volatility.
Using Volatility To Your Benefit
Using options to take advantage of volatility is a great way to deal with the market panics that volatility creates. When volatility increases, it leads to market trepidation. Some options can be used to take advantage of these extreme moves. Or act as a windbreak of the existing positions in cases of severe losses.
In relatively high volatility, the bearish traders may look forward to buying puts on it depending on the twin-end premises of “buying high, selling higher.”
Summing up the trends, ways of measurement, how exactly volatility affects the market. To what extent do investors need to pay heed to it, we conclude that Investors need to watch out for the possible risks of a volatile market. If one has a tried-and-tested strategy, one can choose to stay invested.
The foremost step to dealing with volatility in the stock market is spotting one. It is only then possible for one to decide the correct course of action to follow.
First and foremost is the wide price fluctuations and their effects on the market and understanding market volatility. The key to maintaining your balance in this situation is to have the right strategies to pursue. Always be prepared for what lies ahead. Be able to recoil against any element of surprise that lays ahead.
Stock Market Volatility Conclusion
Stock market volatility is intimidating at first. However, once you understand it, it can be a valuable opportunity to grow your investments. This means always being prepared for opportunities that volatility brings. This is why keeping some liquid capital is always a good idea.
This article should not be all you read on the subject. If you really want to start playing volatility in the stock market, then you have a lot more reading to do.