The concept of volatility is used by investors when referring to changes in financial markets. But how do you know if a market is volatile, and what does this really mean? Here’s a closer look at the meaning of market volatility, and how to best navigate volatile conditions.
What does volatility mean?
You can’t make money in financial markets without prices moving. The degree to which prices rise and fall is called the market’s volatility index. Price volatility offers a way to measure the range of potential returns when talking about a security or market index. Most of the time, the riskier the security is, the higher its volatility will be. In other words, if the stock market is rising and falling significantly over time, it would be called a volatile market.
The significance of low vs high volatility
There are several ways to measure volatility, including looking at the variance or standard deviation between returns. These high and low variances can go in either direction, but they should be greater than 1% over time to qualify as volatile.
While a security’s volatility index measures its price fluctuations, it can also be used to assess risk. If its value is likely to change dramatically in either direction over time, this means it has higher volatility and its price could change accordingly. As a result, high volatility is associated with higher risk. By contrast, low volatility means that the value is steady over time.
Historical vs implied volatility
The meaning of volatility shifts slightly depending on whether you’re looking at future values or historical values.
Implied volatility, or projected volatility, is used by options traders to determine how volatile a market will be in the future. Investors look at the option’s current price and prospects to calculate its potential volatility. This isn’t an exact science, as they’re not looking at historical values.
By contrast, historical volatility looks at measurable values. Investors often look at the historical volatility of a security to assess risk. This is based on historical prices over time, quantifying an asset’s daily returns as a percentage of change. As historical volatility rises, the security’s price moves accordingly with the expectation of change or uncertainty. As the historical volatility drops, this means that the prices level out.
How to take advantage of market volatility
What does this all mean for investors? If you’re looking at how to maximise returns and minimise risk, market volatility is just one important factor to consider.
High volatility equals higher risk, and higher potential reward
Low volatility equals lower risk, and lower reward
Once you’ve decided you want to try and reap the rewards of a volatile market, you’ll need to think about your objectives. Here are a few tips to get started.
1. Put safeguards in place to manage risk.
Trading in volatile markets involves risk, so you need to recognise this and be prepared to guard against it. There are many different ways to manage risk, from diversifying your portfolio to placing smaller trades so that you have less to lose.
2. Look closely at trending stocks.
Although the market may be volatile as a whole, the key to success is to pinpoint the individual stocks that are just beginning to trend upwards before they’ve peaked. In a volatile market, these will give you an opportunity for rapid gains.
3. Play a short-term game.
When markets are less volatile, it makes more sense to look at long-term investment potential. However, in a volatile market you should aim to think in the short term. Set specific profit targets and then sell before profit turns to loss. Another option is to sell part of the position as soon as you start making a profit, holding onto the rest in case the stock continues to trend upwards. You might want to use tighter trailing stops than you normally would.
The bottom line is that the big price swings of a volatile market offer an exciting opportunity for real reward. At the same time, you need to be aware of the risks involved to avoid rapid losses.
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