Everything you need to know about stock market price volatility 

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 the mean or average return of a security.

Volatility can be measured using the standard deviation, which indicates how closely the price of a stock is clustered around the mean or moving average (MA). When prices are tightly clustered, the standard deviation is low. When prices are widely spaced, the standard deviation is important.

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 making 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, because 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. On the other hand, if these do not 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 rise.

As a result, the stock prices of companies related to oil distribution may rise, as one would expect them to profit from, 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. Company performance

Volatility is not always market-wide 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 with the company. If many investors are looking to buy it, this increased demand can help push the stock price up sharply.

In contrast, a product recall, data breach, or poor management behavior can all hurt the stock price as investors sell their stocks. Depending on the size of the company, this positive or negative performance can also have an impact on the wider market.

Types of volatility

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

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 should be in the future, but it does not predict the direction in which the price of the asset will move.

Typically, an asset's implied volatility rises in a bear market because most investors expect its price to continue falling 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 traders use to estimate future price movements of an asset based on several predictive factors.

Realized / historical volatility

Realized volatility, also known as historical volatility, is a way of statistically measuring how the returns of a particular asset or market index are dispersed when analyzed over a period of time.

Normally, 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 security is one that has a high historical volatility value although in some types of trades this is not necessarily a negative factor since bullish and bearish conditions could be risky.

Against these two measures, historical (retrospective) volatility serves as the reference measure,

If the two measures 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 if assets are overvalued or undervalued.

The Standard Deviation Model for Valuing 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 magnitude of a price move.

When calculating the standard deviation of volatility, the variance of a price data set of an underlying asset must be derived. The standard deviation is the square root of the variance.

For illustrative 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 mean at each period. It is the difference between the closing price and the average. For example, on the 7th day, the price of $ 7 deviates from the average $5,5 from 2,5.
• Square the deviation of each period. All 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, which gives traders insight into the possible deviation between the asset price and the average.

As the calculation above shows, standard deviation as a measure of risk assumes that the data set follows a normal distribution, or what is known as 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 taken into account during the calculation.

There is also the 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 against the overall volatility of other tech stocks or even against a comprehensive benchmark stock index.

Benefits of Market Volatility

Volatility is not 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 may provide an opportunity to invest that cash at a lower price. The downward volatility of the markets also offers investors who believe that the markets will perform well over the long term the opportunity to buy additional shares in companies they like, but at lower prices.

A simple example maybe an investor can buy for 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 the markets eventually rebound.

The process is the same when a stock is rising rapidly. Investors can profit 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 presents to generate better long-term returns.