Stock volatility is associated with the risk of a stock or index. Stock market volatility refers to the fluctuations or up and down movement in the value of the overall market. The variation in the movement is measured relative to an average value over a certain period of time. Higher the price swings or fluctuations, higher is the volatility.
The concept is applicable to individual stocks as well. A stock with high volatility can fluctuate significantly over a certain period of time in either direction, while a stock with low volatility does not fluctuate dramatically over a particular period of time.
Traders keep a track of volatility to gauge the market sentiment and capitalize on investment opportunities. However, many conservative investors avoid making investment decisions based on volatility owing to the risk involved.
How is volatility measured?
A statistical measure called standard deviation (square root of variance) is used to measure volatility. It indicates the dispersion of a set of values for a certain period of time from the mean or average value. Higher standard deviation indicates higher volatility.
Aside from standard deviation, volatility of stocks can also be indicated by its beta coefficient. It measures the volatility of the stock relative to the overall stock market. Beta coefficient is calculated by dividing the covariance of a stock’s return with market returns by the variance of market return.
Stock with a beta greater than 1 are more volatile than the market. A beta value between 0 and 1 indicates that the stock is less volatile than the market. If beta is equal to 1, it implies that the stock is as volatile as the market. A negative beta value indicates that the stock has an inverse relation to the market.
For instance, as per TipRanks Stock Analysis tool Nike (NKE) has a beta value of 0.84, which indicates that it is less volatile than the market, while Tesla (TSLA) with a beta of 2.15 is highly volatile compared to the market.
Furthermore, volatility can be historical or implied based on the values used in the computation.
Historical volatility
It indicates deviation in the past values of the market/stock from the average value over a certain period of time.
The above chart by AlphaQuery indicates that Apple’s 30-Day Historical Volatility (Close-to-Close) was 0.2553 on December 24. The Historical Volatility (Close-to-Close) was calculated using the closing price on each trading day for the selected period.
The spike observed in Apple’s historical volatility occurred on August 31, 2020 and was triggered by the 4-for-1 stock split, which made the shares accessible to a larger number of investors because of the lower price.
Implied Volatility
It is a forward-looking measure that reflects volatility expectations over the future and is a key parameter in options pricing.
The VIX (or CBOE Volatility Index) is based on the implied volatility of the S&P 500 Index options.
Volatility Index (VIX)
The CBOE Volatility Index or VIX is a popular measure of stock market volatility and is often referred to as fear gauge or fear index as a higher VIX value indicates higher volatility. VIX, created by the Chicago Board Options Exchange, indicates expected stock market volatility (over the next 30-days) based on real-time prices of options (calls and puts) on the S&P 500 Index.
The VIX Index estimates expected volatility by “aggregating the weighted prices of S&P 500 Index puts and calls over a wide range of strike prices”. The prices used to compute VIX Index values are midpoints of real-time S&P 500 option bid/ask price quotations.
What causes stock market volatility?
There are a wide range of factors that can cause market volatility, like political events (like the recent U.S. presidential elections), macroeconomic news (like unemployment data), changes in fiscal and monetary policy (such as interest rate changes announced by Fed), trade policies (US-China trade war) and any major news that impacts a key industry or sector. The graph above indicates a spike in the VIX earlier this year reflecting the fears related to the COVID-19 pandemic.
Individual stocks can be volatile due to company-specific news like earnings, news on mergers and acquisitions, industry or sector-specific news, and events that are impacting the overall market.
How market volatility affects investors?
Volatility has often been discussed with a negative tone, which is why many investors panics or are concerned when markets are volatile. Conservative investors choose to ignore short-term noise in the market and don’t make any changes to their investments or portfolio based on volatility. But there are many investors who see a market with higher volatility as an opportunity to rebalance their portfolios. For instance, an investor might buy a stock that has fallen to an attractive price point amid the current volatility as he believes that company has strong growth prospects.
Conclusion
Market volatility indicates the deviation of the stock market from the average value. It is important for investors to understand the concept of volatility at the market as well as the stock level and the factors which are causing volatility. Though there are several investors and traders who seek investment opportunities in markets with high volatility, average investors should be aware that high potential returns are associated with high risks during such times.