When reading financial media, you’ll often come across statements like “the stock trades on high volatility.” But what is market volatility, and what does it mean when it comes to your investment portfolio’s bottom line?
What Is Stock Market Volatility?
In the most simple of explanations, stock market volatility is the rate at which stock prices move up and down in the short term.
Put simply, stocks or stock market indexes that experience high volatility tend to move up and down rapidly. On the other hand, low-volatility stocks tend to experience more stable growth or declines in the stock market.
Volatility is important to investors as it gives an idea of the risk and reward associated with the investment. In fact, volatility can be calculated to get a measure of the average gain or loss that can be expected based on recent movements in stock prices.
How to Calculate Historical Volatility
At first, the calculation for volatility will seem a bit complex. However, once you practice it a few times, you’ll find it’s actually pretty simple. The calculation uses variance and standard deviation to give investors an idea of the risk and potential profitability associated with stock market investments.
For example, let’s say that you invest in a stock at $1 per share that increased in value by $1 per month for a period of nine months. In order to calculate volatility, you’ll need to start by calculating the variance.
To do so, add up the values of the investment at the close of each month. In this case, you would start with $1 and add $2, $3, $4, $5, $6, $7, $8, $9, and $10. Doing so, you’ll end up with a total of $55.
- Mean Price: Because there are 10 points of data in the data set, you can divide this total by 10 to find the average — or mean — price over the term of the investment: in this case, $5.50.
- Deviations: Now, subtract the mean from each point of data in the set. For this example, you would subtract $5.50 from $10, then $5.50 from $9, and so on, all the way down to $1. Keep in mind that as you get to the lower numbers in the data set, you will end up with negative numbers. The results from these subtractions are known as deviations.
- Variance: Once you have all deviations, square them — simply multiply them by themselves. This will get rid of all negative values. Then add all these squared numbers together. In this example, your total will come to $82.50. Now, divide this total by the number of data points — in this case, 10 — and you will come to a variance of $8.25.
- Standard Deviation: Now, take the square root of the variance to find the standard deviation — in this case, the standard deviation is $2.87. Standard deviation is a statistical measure of historical volatility. Standard deviation tells you the “normal” amount of movement you would expect in a stock given its historical variance. As a result of this example calculation, investors and traders would come to the conclusion that if the stock is purchased at current price levels, it will most likely move up or down by around $2.87 over the next month.
You can avoid the math by using this Standard Deviation Calculator.
Investors and traders often use historical data as an indicator of future market moves. This is the result of a widespread belief that history repeats itself in the stock market.
Therefore, by analyzing historical data, it’s possible to make predictions as to how individual stocks or the broad market is likely to behave in the future.
Why It’s Important to Pay Attention to Volatility
At first glance, paying attention to the scale of short-term swings in market valuations seems pointless for many. After all, investing is a long-term game, best played by those with the ability to ignore short-term movements and focus on long-term goals.
So, why is volatility important?
Measuring volatility tells you two key things about the stocks or financial assets you’re interested in:
- Risk. Volatility tells you approximately how risky a stock or other investment vehicle is. Well-established companies with solid track records of growth tend to move in slow, stable motions. When price movement happens quickly, it means that the value of the security is hotly debated in the investing community. There’s usually much less debate when it comes to a strong, established, stable company.
- Opportunity. Some investors are willing to accept higher levels of risk in exchange for a larger opportunity for gains. While stocks with high volatility generally come with high levels of risk, the wide swings in value mean that buying low and selling high has the potential to lead to a fast payout. Although many believe that timing the market is impossible, some savvy traders earn an impressive living doing just that. Nonetheless, there’s no question that timing the market is difficult and should only be attempted by experienced investors.
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The CBOE Volatility Index (VIX)
Volatility can be measured on a per-asset basis or in the market as a whole. Looking at market-wide volatility gives you an understanding of overall investor opinion and what direction the overall market is likely headed in the short term.
The good news is that you won’t have to do the calculations to get a view of this opinion across the overall market. That’s why the CBOE Volatility Index, or VIX, was created.
The index was created by the Chicago Board Options Exchange (CBOE), which later changed its name to CBOE Global Markets. The VIX has grown to become the benchmark index for measuring fear and greed in the overall market.
The VIX is a real-time market index that gives investors a view of 30-day forward-looking volatility. Importantly, this is a forward-looking indicator.
There is no 100% reliable way to tell the future, and forward-looking indicators will prove to be highly inaccurate from time to time. Nonetheless, the VIX has proven to be shockingly accurate for the most part. Much of this accuracy comes from how the data in the CBOE Volatility Index is derived.
The VIX measures data from S&P 500 index options. Options give investors the right to buy or sell an underlying asset at a later date for a predetermined price.
By measuring data from S&P 500 index options, the CBOE Volatility Index is able to gauge whether the investing community is feeling fearful or greedy in terms of future price movements. In fact, the VIX is often called the fear gauge or fear index.
Even buy-and-hold investors should pay close attention to sentiments of fear and greed in the market when adjusting their portfolios or thinking about entering into new positions. When the broad market is fearful, or bearish, the expectation is that prices will fall ahead.
So, if the index suggests that fear is high, it may be best to look to safe havens.
On the other side of the coin, when market participants are feeling greedy, they believe that the values of stocks will rise; the market will be bullish. During these times, investments in traditional stocks tend to yield larger returns.
Price fluctuations in the overall market depend on the opinions of investors. Because the VIX measures the overall opinions of market participants, it has an uncanny history of providing reliable predictions as to the future volatility of the broad market.
What Is Implied Volatility?
When researching stock market volatility, you’re likely to come across the term “implied volatility.” It’s a commonly used tool by investors, specifically in the pricing of options contracts.
When a security trades with high levels of implied volatility, options contracts surrounding that security will trade at a premium. When implied volatility is relatively low, the opposite is true.
Implied volatility is used to project future moves in supply and demand by analyzing the market’s opinion with regard to the likelihood of price changes. Implied volatility generally increases in bear markets and decreases when markets are bullish.
It’s important to keep in mind that implied volatility tells you nothing in terms of which direction price changes will be.
A high level of implied volatility means that the asset realizes wide swings in value, while a low level of implied volatility means that the asset realizes relatively stable movement. Whether those swings or movements will be in the upward or downward direction is not indicated in any way by the implied volatility of the asset.
Ultimately, implied volatility is a measure of supply and demand for individual stocks and other securities over time. By measuring supply and demand, the indicator provides a relatively accurate gauge of whether a stock is likely to see wide swings in value or move in slow and steady motions.
As with the CBOE Volatility Index, implied volatility is a forward-looking indicator, meaning it uses current data in an attempt to predict the future. Because it’s impossible to predict the future, implied volatility does not provide a 100% accurate gauge of future market movement, which should be considered when using it to make investment decisions.
Volatility and Risk Tolerance
If there’s one lesson that you hold onto from this article, it should be the fact that volatility is a measure of risk. Understanding your unique risk tolerance and centering your investing strategy around it is important. Doing so helps to avoid emotion-based decisions that can lead to significant losses.
Investing in assets that are known for high levels of volatility will inherently come with high levels of risk. So, it’s best to make sure the level of volatility of assets in your portfolio is heavily correlated to your level of risk tolerance.
If you have a high risk tolerance, investing in high-volatility stocks will be appealing. However, if you have a low risk tolerance, it’s best to stick with stocks that are known for low levels of volatility.
Where to Find High-Volatility Stocks
If you’re looking for high-risk, high-reward opportunities in the stock market, high-volatility stocks are where you want to be. Digging them up isn’t difficult. Some of the best places to find high-volatility stocks are:
- Penny Stocks. Penny stocks tend to come with high levels of risk and are hotly debated by investors and traders alike. Often driven by speculation, penny stocks are known for high volatility.
- The Tech Sector. In most cases, high-volatility stocks trade in the penny and small- and mid-cap range. However, the tech sector breaks that rule. Names like Amazon.com, Microsoft, and Apple are all massive, well-known, well-established companies. However, they also tend to trade with high levels of volatility.
- Biotechnology Stocks. Developing a new treatment for a devastating condition can generate billions of dollars in revenue per year. So, even some established biotech companies are hotly debated and enjoy high volatility as a result of speculation surrounding their pipeline of clinical candidates. As a result, biotechnology stocks are often a way to access wide swings in value while protecting yourself from the potential insolvency often seen among penny stocks.
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Where to Find Low-Volatility Stocks
Low-volatility stocks are best for most investors. This is especially true for beginner investors. The corners of the overall market that generally contain low-volatility stocks include:
- Utilities. Utilities companies generally have a captured audience. For example, if you’re like most Americans, there’s only one or two power providers that serve your area. The same goes for most other utilities. And, no matter the conditions of the economy, you’re not going to go without power, water, sewage, and other basic essentials. This fact makes utilities stocks incredibly stable, low-volatility investment opportunities.
- Blue-Chip Stocks. Blue-chip stocks are a class of stock that represents the best of the best. These are long-standing companies that have captured their market and are responsible for the term “too big to fail.”
- Conglomerates. Conglomerates are often also blue-chips. These are companies that started in one area of business and invested in a long line of subsidiaries. As a result, conglomerates stocks often trade with low volatility.
One of the perks to investing in low-volatility stocks is that these stocks tend to come with strong dividends. Because these companies are established, profitable, and have a strong understanding of what to expect in the future, they are known for returning value to investors through both dividends and share buybacks.
Many Prefer a Diversified Mix
Sticking to one class of stock is generally a bad idea. Instead, investors practice diversification in order to take advantage of high-reward opportunities while tapering risk down with safer bets. Most investors will benefit from a diversified mix of both high-volatility and low-volatility stocks.
There are a few factors to consider in terms of volatility diversification:
- Balance Risks. High-volatility stocks will generally come with higher levels of risk than low-volatility stocks. However, you don’t have to accept the highest levels of risk in order to mix some high-volatility opportunities into your investment portfolio. If you’re a newcomer to the stock market or have a relatively low risk tolerance, consider looking at established tech companies or biotech companies as a way to tap into volatility while reducing the risk of doing so.
- A Healthy Mix. There’s no real rule of thumb for the percentages of your investment portfolio that should be invested in high-volatility and low-volatility investment vehicles. As with just about anything in the world of investing, when it comes to high-volatility stocks, it’s best to start small, then grow. If you’re unfamiliar with high-volatility stocks, start with a 5% allocation to this class of investment. If you find success and want to expand your high-volatility holdings, do so slowly until you feel that your investment portfolio is properly in line with your unique level of risk tolerance.
Volatility is a great way to gauge the levels of risk both in individual stocks and across the overall market. However, as with any indicator, volatility isn’t always going to be 100% accurate.
For example, if you’re chasing volatility and find a stock that seems like it will experience wide swings in value, it’s possible that the wide swings that set off your volatility alarms may have been caused by short-term news or promotional activities. As such, those wide swings in value may flatten out quickly.
Moreover, a stock that trades with relatively low levels of volatility may announce an accounting error or another horrible bit of news. In these cases, the low-volatility stocks you’re interested in may result in significant losses.
Although measuring volatility is a great addition to any investor’s toolbox, it should not be the sole basis of an investment decision. Prior to making any investment decisions, it’s important to research the opportunity in great detail to get a full understanding of the risks and rewards associated with your investment.