Volatility is often understood as a strong price movement. If yesterday and the day before yesterday the price remained almost unchanged, and today it has skyrocketed, volatility has increased. Or the price moves with a large amplitude in both directions – the market is volatile. Both interpretations are only partly correct. The volatility of financial markets is a relative concept. This is a parameter that can only be used when there is a base to compare against. By itself, volatility does not mean anything and can, on the contrary, lead to a forecast error.
From the review you will learn:
- What is volatility? Types of volatility.
- How to calculate volatility.
- How to interpret financial market volatility.
Also in the next review, we will compare the volatility of individual markets and assets with each other.
What is financial market volatility
The volatility of financial markets is a measure, a parameter that allows you to determine the degree of price volatility over a fixed period of time. It is always determined with respect to another criterion:
- Relative to an earlier time period.
- Relative to another asset.
- Relative to different lengths of time sections with the same amplitude of movement.
- The share price fluctuated within +/- 5% in March. In April, the price range increased to +/- 15%. We can say about such a stock that its volatility increased in April – the asset became more volatile.
- The share price fluctuated within +/- 15% in March. In April, the share price fluctuated within +/- 16%. Since the amplitude of movement almost did not change in April, the stock belongs to non-volatile assets. Please note: it is not the width of the range of motion that is important, but its comparison with the previous period.
Example 2 Company A’s stock fluctuates in the +/- 5% range, company B’s stock fluctuates in the +/- 15% range. The compared time interval is the same (this is important!). Company B’s stock is more volatile than Company B’s stock.
Please note: previous periods can be compared separately (for example, volatility at the time of the crisis). And the current period. The information obtained can help determine the company’s resistance to force majeure: if the volatility is almost unchanged, the stability is high.
Example 3 Company B shares are up 15% in 3 months, Company B shares are up 15% in 12 months. We can say about company A that its shares are more volatile – its price changes more dynamically. And while company B’s shares go up 15%, company A’s shares can rise 15% over the same period, return to the starting point and go up again.
Volatility is historical and expected. These approaches are most common, but in fact, investors evaluate it visually. Historical volatility involves the calculation of the parameter based on historical data. Expected – calculation of historical volatility, taking into account future risks. For example, the publication of a company’s financial statements is likely to cause an increase in the dynamics of price movement. But the level of risks can be assessed and put into the trading system – the placement of stops, take profits and pending orders.
A simple way to calculate volatility is to subtract the opening and closing prices of the candles of the analyzed period. This option is discussed here. The mathematical approach involves the use of the standard deviation formula – the level of price deviation from its average value. Do not confuse with the Standard Deviation indicator. For volatility, the standard deviation is calculated not on the basis of the opening/closing price of a candle, but on the basis of the difference between the closing prices of the current and previous candles.
The volatility of financial markets is a statistical indicator. There are no specific suggestions on how to use it. Possible options:
- If the expected volatility increases (for example, news is expected), it is better to close the trades in advance. Or increase the length of the stops, if risk management allows.
- If the expected volatility will temporarily increase, you can apply scalping strategies or place a grid of orders.
Assets with low volatility are more suitable for long-term strategies, while those with high volatility are more suitable for quick earnings.