Everything you need to know about stock price volatility

Stock price volatility is an investment term that describes when a market or security experiences periods of unpredictable and sometimes abrupt price movements. People often only think of volatility when prices are falling. But volatility can also refer to sudden price increases. Strictly speaking, volatility is a measure of the dispersion around a security's average or mean return.

Volatility can be measured using the standard deviation, which indicates how tightly a stock's price is clustered around the mean or moving average (MA). When prices are tightly clustered, the standard deviation is small. When prices are widely spaced, the standard deviation is large. In this article, we are basically talking about stock market volatility. Let's go

What causes volatility?

There are many factors that can cause asset price volatility in the market. In this article, we present just a few of these elements. Read until the end.

1. Political and economic factors

Governments play a major role in regulating industries and can impact an economy when they make decisions about trade agreements, legislation, and policy. Everything from speeches to elections can cause reactions among investors, which influences stock prices.

Economic data also plays a role, as when the economy is doing well, investors tend to react positively. Monthly employment reports, inflation data, consumer spending figures, and quarterly GDP calculations can all impact market performance. However, if these fail to meet market expectations, markets can become more volatile.

2. Industry and Sector Factors

Specific events can cause volatility within an industry or sector. In the oil sector, for example, a major weather event in a major oil-producing region can cause oil prices to increase. As a result, the stock prices of companies related to oil distribution may rise, as would be expected to benefit them, while the prices of those with high oil costs in their business may fall.

Similarly, increased government regulation in a specific industry could cause stock prices to fall, due to increased compliance and labor costs that could impact future earnings growth.

3. Business performance

Volatility is not always on a market scale and may concern a sole proprietorship. Positive news, such as a strong earnings report or a new product that appeals to consumers, can make investors happy about the company. If many investors are looking to buy it, this increased demand can help push the stock price up sharply.

On the other hand, a product recall, data breach, or poor management behavior can all hurt the stock price as investors sell their shares. Depending on the size of the company, this positive or negative performance can also impact the broader market.

Types of volatility

Volatility is one of the factors that investors in financial markets analyze when making decisions. There are two key approaches to volatility, each with its own advantages and disadvantages:

Implied volatility

The term implied volatility describes the estimated volatility of an asset and is a common feature of options trading. Implied volatility reflects how the market perceives where volatility is expected to be in the future, but it does not predict the direction in which the asset's price will move. Typically, an asset's implied volatility increases in a bear market because most investors expect its price to continue to decline over time.

It decreases in a bull market because traders believe the price is bound to rise over time. This is due to the common belief that bear markets are inherently riskier than bull markets. Implied volatility is one of the metrics that traders use to estimate future price fluctuations of an asset based on several predictive factors.

Realized / historical volatility

Realized volatility, also known as historical volatility, is a way to statistically measure how the returns of a particular asset or market index are dispersed when analyzed over a given period of time. Typically, historical volatility is measured by establishing the average deviation of a financial instrument from its average price over a given period of time.

The standard deviation tends to be the most common measure of realized volatility, although there are other methods used to calculate this metric. A risky stock is one that has a high historical volatility value although in some types of trading this is not necessarily a negative factor since both bullish and bearish conditions could be risky.

Compared to these two measures, historical (retrospective) volatility serves as a reference measure. If both metrics show similar values, then an asset is considered to be fairly priced based on historical standards. For this reason, traders look for deviations from this balance to determine whether assets are overvalued or undervalued.

The standard deviation model for assessing financial volatility

Standard deviation is a measure used to statistically determine the level of dispersion or variability around the average price of a financial asset, making it an appropriate way to measure market volatility. Generally speaking, dispersion is the difference between the average value of an asset and its true value.

The higher the dispersion or variability, the higher the standard deviation. The smaller the variation, the smaller the standard deviation. Analysts often use standard deviation as a way to measure expected risk and determine the significance of a price movement. When calculating the standard deviation of volatility, the variance of a set of price data of an underlying asset must be derived. The standard deviation is the square root of the variance.

For illustration purposes, we will consider the price of an underlying asset that has increased uniformly by 1 $ to 10 $ in 10 trading periods. The standard deviation will be derived in the following steps:

• Calculate the average of the 10 trading days. This is done by adding the prices ($1, $2… to $10) then dividing it by 10 (in this case, the total number of prizes). The sum of 55 divided by 10 will be $ 5,5.
• Determine the deviation from the average at each period. This is the difference between the closing price and the average. For example, on the 7th day, the price of $ 7 deviates from the average of $5,5 from 2,5.
• Square the deviation of each period. Any periods with negative deviations will be eliminated by squaring them.
• Add the squared deviations. According to our example, the sum is $ 82,5
• Divide the sum by the number of periods, in this case, 10. This will be $ 8,25.
• The standard deviation is the square root of this number. In this case, the standard deviation is 2,75 $, which reflects the distribution of values ​​around the average price, giving traders insight into how far the asset's price may deviate from the average.

As the calculation above shows, the standard deviation as a measure of risk assumes that the data set follows a normal distribution, or what is called a bell curve. In such a scenario, as above, 68% data will fall within one standard deviation; 95% will be located in two standard deviations and 99,7% data will fall within three standard deviations.

But there are some limitations to using standard deviation as a measure of volatility. For starters, prices or returns are never uniform, and they are punctuated by periods of sharp increases in both directions. This means that the standard deviation itself can fluctuate depending on the periods considered in the calculation. There are also la beta method (Β) to measure or calculate volatility. In this method, the volatility of an underlying asset is measured relative to other related assets.

For example, Apple stock volatility can be measured relative to the overall volatility of other tech stocks or even a comprehensive benchmark stock index.

Benefits of Market Volatility

Volatility isn’t always a bad thing. Market corrections can also sometimes provide entry points that investors can take advantage of. If an investor has cash and is waiting to invest in the stock market, a market correction can provide an opportunity to invest that cash at a lower price. Downward market volatility also provides investors who believe the markets will perform well in the long term with an opportunity to buy additional shares in companies they like, but at lower prices.

A simple example maybe an investor can buy 5O? $0, a stock that was worth $100 a short time ago. Buying stocks this way lowers your average cost per share, which helps improve your portfolio’s performance when markets eventually rebound. The process is the same when a stock rises quickly. Investors can take advantage by selling, the proceeds of which can be invested in other areas that offer better opportunities.

By understanding volatility and its causes, investors can potentially take advantage of the investment opportunities it offers to generate better long-term returns.