- With investments, volatility refers to changes in an asset’s or market’s price – especially as measured against its usual behaviour or a benchmark.
- Volatility is often expressed as a percentage: If a stock is ranked 10%, that means it has the potential to either gain or lose 10% of its total value. The higher the number, the more volatile the stock.
- Though volatility isn’t the same as risk, volatile assets are often considered riskier because their performance is less predictable.
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If you’re thinking about investments, one term that you’ve likely heard thrown around a lot is “volatility.”
In the non-financial world, volatility describes a tendency toward rapid, unpredictable change. When applied to the financial markets, the definition isn’t much different â€” just a bit more technical.
Market volatility is defined as a statistical measure of a stock’s (or other asset’s) deviations from a set benchmark or its own average performance. Loosely translated, that means how likely there is to be a sudden swing or big change in the price of a stock or other financial asset.
Not surprisingly, volatility is often seen as a representative of risk in investments, with low volatility signalling safety and positive results, and high volatility indicating danger and negative consequences.
Think of it like riding a bicycle. You’re never guaranteed a safe ride when you get on. Little occasional wobbles are a typical part of the trip and usually fly by unnoticed. But if you suddenly swing wide to avoid an obstacle, your course becomes harder to correct, increasing the likelihood that you’ll lose your balance and crash.
Some paths come with fewer twists and turns than others. Assessing the risk of any given path â€” and mapping out its more hair-raising switchbacks â€” is how we evaluate and measure volatility.
And more importantly, understanding volatility can inform the decisions you make about when, where, and how to invest.
Types of volatility
There are two types of market volatility:
- Historical volatility, which makes observations by looking back
- Implied volatility, which makes predictions by looking forward
Historical volatility (HV), as the name implies, deals with the past. It’s found by observing a security’s performance over a previous, set interval, and noting how much its price has deviated from its own average.
If historical volatility is going up, it’s a cause for caution, as that can indicate something happening or about to happen with the underlying security. If it’s going down, it means things are returning to normal and stabilizing.
Implied volatility (IV), aka future volatility, is more complicated. It’s a forecast of an asset’s future activity based on its option prices. (Quick refresher: an option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date.)
HV and IV are both expressed in the form of percentages, and as standard deviations (+/-). If you say XYZ stock has a standard deviation of 10%, that means it has the potential to either gain or lose 10% of its total value. So the higher that number gets, the more volatile the stock.
How is volatility predicted?
Implied volatility takes five metrics â€” the option’s market price, the underlying asset’s price (spot price) strike price, time to expiration, and the risk-free interest rate â€” and plugs them into a formula (see below). You then back-solve for implied volatility, a measure of how much the value of that stock is predicted to fluctuate in the future.
Say you have two similarly priced stocks and you retrieve put and call (sell and buy, respectively) options for them with the same amount of time until expiration. You might expect to see similar put and call prices. When you don’t, that’s when IV becomes a factor: Stocks with more expensive options also have a higher implied volatility.
The Black-Sholes model
The IV equation described above is known as the Black-Sholes formula, a mathematical model designed to price options on the stock market. It looks like this:
It isn’t necessary that you understand every aspect of the formula to be able to grasp the concept of implied volatility, but noting the position of the six crucial elements can be helpful. On the far left, C stands for the call option price, with the normal distribution (N), spot price (St), strike price (K), risk-free interest rate (r), and time to maturity (t) on the right side of the equals sign, and implied volatility (Ïƒ or sigma) buried within the formulas for d1 and d2. (This is why you need to back-solve to find it, as the above equation solves for C.)
The CBOE Volatility Index
For a more macro look at volatility, financial pros turn to the CBOE Volatility Index (VIX). Created by Chicago Board Options Exchange, it’s commonly referred to as the stock market’s “fear gauge,” because it provides a snapshot of the market’s predictions regarding volatility for the next 30 days (which is then annualized to provide a prediction set for the next 12 months.)
VIX does that by looking at put and call option prices within the S&P 500, a benchmark index often used to represent the market at large. Those numbers are then weighted, averaged, and run through a formula that expresses a prediction not only about what might lie ahead but how confident investors are feeling.
When the VIX is rising, volatility is rising, and often the market’s getting shaky. When the VIX is high (above 30), it’s generally considered a tricky time to invest, and vice versa when it’s low. (Of course, when other investors are fleeing the market, it can represent a moment for those with a strong stomach to swoop in and make some money â€” hence the trading expression: “When the VIX is high, it’s time to buy.” )
Is volatility the same as risk?
Based on the definitions shared here, you might be thinking that volatility and risk are synonymous. But they’re not.
Volatility is a prediction of future price movement, which encompasses both losses and gains, while risk is solely a prediction of loss â€” and, the implication is,permanent loss.
Obviously, the two are related. And volatility is a useful factor when considering how to mitigate risk. But conflating the two could severely inhibit the earning capabilities of your portfolio.
What causes volatility?
As an indicator of uncertainty, volatility can be triggered by all manner of events. An impending court decision, a news release from a company, an election, a weather system, or even a tweet can all usher in a period of market volatility. Any abrupt change in value for any underlying asset â€” or even a potential change â€” will inject a measure of volatility into the connected markets.
Defining market volatility comes with a surprisingly low bar: any time the market moves up and down by one percentage point or more over a sustained period, it’s technically considered a volatile market.
That said, the implied volatility for the average stock is around 15%. So tread carefully anytime you see an asset with an IV over 20%.
Of course, values are constantly rising and falling, so a certain amount of implied volatility is to be expected. Some sectors experience this phenomenon more acutely than others, however. For example, energy and commodities stocks saw standard deviations of 20.3% and 18.6% respectively, during the 2010s. (Remember: the average is 15%.)
And there’s always the potential for unpredictable volatility events like the 1987 stock market crash, when the Dow Jones Industrial Average plummeted by 22.6% in a single day.
The financial takeaway
Volatility is not inherently bad.
For traders, or anyone interested in being a little more hands-on with their portfolio, volatile assets are positively brimming with potential. That’s because implied volatility doesn’t indicate the direction the stock is predicted to take: The value is just as likely to go up as it is to go down, offering up a potential windfall for investors. If you successfully buy low and sell high, you can make volatility work for you.
Volatile assets do bear watching â€” though they can suit a passive investor’s buy-and-hold strategy: If you have enough runway before retirement (or whatever the long-term goal), the swings will likely be evened out. Of course, highly volatile assets might not be a good fit for an investor on the verge of retirement or cashing out. Or for anyone who requires steady income from their investments.
At the end of the day, volatility has no moral implications: It’s just a fact of investing life. And it does bear repeating: Implied volatility is merely a prediction. No one can see the future, so no one knows how any given asset will actually behave.
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