Market Volatility: What Is It and How It Works

The term ‘market volatility’ is used by investors when referring to changes in certain financial markets.

This is an investment term that describes when a market or security experiences unpredictable behaviour which can manifest itself in sharp and unpredictable price movements. 

Many investors associate volatility with negativity, believing that volatile markets only happen when prices fall, but it can also refer to sudden price rises too. 

But what actually is market volatility and what causes it? And does a volatile stock represent a buy opportunity for investors? Let’s take a deeper look into the meaning of market volatility and how investors can navigate an unpredictable market: 

What is Market Volatility?

Market volatility is a statistical measure of the dispersion of returns for a given asset or market index. In many cases, the more volatile a stock is, the riskier it becomes. Volatility tends to be measured as either the standard deviation or variance between returns from a stock or market index. 

In securities markets, volatility can be associated with significant swings both up and down. For instance, when the stock market rises and falls more than 1% over a sustained period, it’s generally referred to as a ‘volatile’ market. The level of volatility that an asset experiences is important when pricing options contracts. 

Volatility tends to refer to the level of uncertainty or risk related to the size of changes in a stock’s value. More volatility means that a security’s value can potentially be spread out over a larger range of values. This indicates that the price of the security has the ability to change dramatically over a short time period in either direction. Lower volatility means that a security’s value doesn’t fluctuate dramatically and is typically more steady. 

(Image: Fisher)

Above we can see the overall volatility of the S&P 500 charted, with notable factors in American and world history causing prices to fluctuate. Despite many significant downturns, we can see that the S&P has overall appreciated by 12,577% – showing that volatility can offer strong buy opportunities in a market that correlates upwards over time. 

One way to measure an asset’s variation is to quantify the daily returns (the percent move on a daily basis) of the stock. Historical volatility is based on past prices, and it represents the degree of variability in the returns of an asset. This number is without a unit and is expressed as a percentage. 

Although variance captures the dispersion of returns around the mean of a stock in general, volatility is a measure of that variance over a certain timeframe. This means it’s possible to report daily volume, weekly, monthly or on a yearly basis. This means that it’s handy to consider volatility as an annualised standard deviation. 

The Impact of Volatility on Market Performance

In a 2020 report, Crestmont Research studied the historical relationship between stock market performance and its volatility. Crestmont used the average range for each day in order to measure volatility of the S&P 500. Their findings showed that higher volatility typically relates to the higher probability of a declining market, while lower volatility is related to a rising market. This means that investors can utilise this data to further optimise their portfolios to drive more consistent returns. 

For instance, when the average daily range in the S&P 500 is low (between 0% and 1% in the first quartile), the odds are higher (around 70% monthly and 91% yearly) that investors will accumulate 1.5% monthly and 14% yearly. 

When the average daily range moves into the fourth quartile at 1.9% to 5%, there’s a larger probability of a 0.8% loss for the month and a 5/1% loss for the year. These effects on volatility and risk are consistent across markets, with the exception of cryptocurrency – which is largely characterised by levels of extreme volatility that’s unimaginable in the more traditional stocks and shares landscape. 

What Causes Market Volatility?

When it comes to stocks, causes of market volatility can be both internal and external to specific tickers and their markets: 

1. Political and Economic Impacts

Global governments can play a significant role in regulating industries and impacting economies when they make decisions on trade agreements, legislation and policy. Factors as simple as speeches or as complex as elections can drive sharp reactions from investors – leading to huge ramifications on the share prices of assets. 

Economic data can also play a role, as when a company is performing well, investors typically react in a positive manner. Monthly jobs reports, inflation data, consumer spending and quarterly GDP estimates can all greatly influence market performance. However, if such market expectations are missed, this can herald a period of greater volatility within markets. 

External economic factors can lead to wider downturns like recessions, which invariably leads to large scale sell offs across the market. Although this can impact share prices in the short term, it can also represent a low-cost buying opportunity when investors believe the market bottom has arrived. 

2. Industry and Sector Impacts

Certain events can cause volatility within an industry or sector. Let’s look at the oil sector, for instance. If a major weather event in an oil-producing area occurs, this can lead to oil prices increasing. As a result of this, the share price of oil distribution-related companies could rise, as investors may expect them to directly benefit – while the prices of companies that have high oil costs within their business could fall. 

Furthermore, greater levels of government regulation in a certain industry could lead to sharp falls in stock prices owing to the levels of compliance and employee costs that could influence future earnings growth. 

3. The Performance of Companies

The performance of companies themselves can also impact volatility, rather than external governmental or unforeseeable impacts.

For example, positive news surrounding a company, such as a good earnings report or a high-performing new product, can build investor confidence – leading to more demand for stocks as new buyers look to get in on the appreciating asset. 

However, if a product has to be recalled due to unsafe parts, or a data breach occurs, or a prominent member of the company finds themselves in legal trouble, share prices may fall as investors sell off their shares. 

Depending on the size of the company, positive or negative performances can also cause an impact on the broader market. 

4. Foreign Volatility

Modern economies are interconnected on a global scale. This means that whatever happens around the world could play a significant role in the prices of domestic companies listed on domestic marketplaces. 

Factors like wars, regime changes and revolutions in countries around the world could all have the potential to interrupt trade, the flow of money, investments and sentiment between companies and the international corporations that operate around them. 

5. Positive and Negative PR

As we’ve touched on in point three, volatility doesn’t always occur on a market-wide scale. An individual company can see its stock performance overperform or underperform based on whether it’s having a good or bad time in terms of its public relations strategies. Depending on the size of the company, its PR performance could have a greater effect on the markets. 

While good PR performance can make a significant difference to the performance of a company’s stocks, bad press can send it tumbling in the short term. For instance, in the wake of Facebook’s Cambridge Analytica scandal regarding user privacy in 2018, the social media giant’s stock price fell 40% from its peak before mounting a steady recovery. However, due to Facebook’s strength across the tech sector, the company’s fall triggered wider market volatility as other tech investors were scared into sell-offs. 

However, this PR can work to a company’s advantage in a significant manner too. When Apple launched its iPhone X, it came off the back of a strong quarter – subsequently, shares opened 3% higher the morning the product was released to the public. 

Is Trading in Volatile Stocks a Good Idea?

Although volatile stocks can indicate a market that’s ready for decline, many traders seek out shaky assets in order to capitalise on their volatility. 

The reason why many traders look to volatile stocks is simply that they can generate higher returns. Investors who trade in volatile stocks have a better chance of capitalising on erratic prices rather than investors who play it safe and stay trading in low-volatility stocks. 

For volatility traders, gross profit isn’t the only impact a portfolio will see, and volatility can make an attractive difference when it comes to net profitability, too. Essentially, if you’re looking to create a significant income through investing in stocks, you’ll have to be willing to leverage a larger profit margin. The best way of achieving this is to take the risk against more volatile stocks.

Fundamentally, without some degree of volatility, it’s difficult to trade effectively. Price fluctuations are necessary when it comes to stock markets to take any short term profits at all. With this in mind, the question isn’t whether or not trading stocks is a good idea, rather it’s how volatile you should be willing to go with your trading. 

Using volatility as a key determinant of stocks selections can be difficult but rewarding when the approach pays off. High upswings will often lead to high profits. However, it’s important to note that losses can be equally as likely. Bear in mind that if you’re tempted by the prospect of gains, you must also be ready for the possibility of seeing losses also. 

Don’t feel discouraged from investing in some of the market’s more volatile stocks. It can pay to be strategic about your approach towards volatile stocks. 

Measuring Volatility

One of the best ways of charting volatility in the markets is through analysing the Cboe Volatility index (VIX). VIX is a real-time index that represents the market’s expectations for the strength of near-term price changes in the S&P 500 index. Because it’s derived from prices in the S&P 500 it creates a 30-day projection of anticipated upcoming volatility. 

As the VIX shows, the arrival of the Covid-19 pandemic sent market volatility soaring to levels that haven’t been seen since the market crash of 2008. Much of 2020’s trading was punctuated by this volatility, with levels showing signs of reverting towards familiarity in places across 2021. 

How does the VIX measure volatility? For financial instruments like stocks, volatility is a statistical measure of the degree of variation of their trading price over a specific period of time. 

Volatility can be measured in two ways. The first is based on statistical calculations regarding historical prices over a specific period of time. This process is based on computing a range of statistical numbers, like mean, variance and standard deviation among historical price data sets. 

The resulting value of standard deviation is a measure of risk or volatility, and it can help to expose undervalued stocks that may have attained an advantageous price following a period of volatility. 

In spreadsheet programs like Excel, volatility can be computed by applying the STDEVP() function on the range of stock prices. Although, the standard deviation method is based on many assumptions and may not be a foolproof method for measuring volatility. As it’s based on past prices, the results are called ‘realised volatility’ or ‘historical volatility’. To anticipate volatility into the future, a popular approach is to look at past months and to anticipate similar patterns continuing. 

Another popular way of measuring volatility involves inferring its value as implied by option prices. Options are derivative instruments where its price depends on the probability of a stock’s price moving up or down to the point where it reaches a specific level (known as a strike price or exercise price). 

For instance, Investopedia clarifies this approach by imagining IBM stocks are currently trading at a price of $151 per share. There’s a call option on IBM with a strike price of $160 and it has one month until it expires. The price of this call option depends on the market perceived probability of IBM stock moving from its current price of $151 to surpass the strike price of $160 within said month. 

As the possibility of this move happening is represented by the volatility factor, various option pricing methods include volatility as a key input parameter. Since option prices are available in the open market, they can be used to derive the volatility of underlying security. Such volatility, as implied by or inferred from various market prices, is called forward-looking ‘implied volatility’. 

It’s important to note that both methods have their own individual drawbacks and perks, they are both relatively effective in terms of volatility calculation that can offer reliable market insights in a range that can be used to make predictions. 

How to Use Market Volatility to Your Advantage

Due to global government stimulus packages and advancing fintech platforms that allow easy and cost-effective access to the stock market, we’re seeing larger volumes of retail investors entering the market in a bid to find their feet and pick up assets that appear to be undervalued. 

If you’re an investor aiming to maximise your returns whilst minimising risk, market volatility is imperative to take into account. After all, high volatility means higher risk, and potentially greater returns – whilst lower volatility tends to equate to lower risk and lower reward levels. 

Once you’ve decided that you want to delve into the riskier volatile markets, it’s important to consider your objectives. Let’s take a deeper look at some tips to help you find your feet within volatility: 

1. Set Clear Objectives For Your Trading

Before you embrace trading within volatile markets, make sure you’re both mentally and tactically prepared to manage the risks involved. With this in mind, it’s important to consider the following: 

• That you’re both comfortable and happy to trade during times of greater market volatility
• That you recognise the greater potential for steep losses of capital, and that you’re prepared for this added level of risk

If you’re happy to trade in volatility despite these implications, the next vital thing for you to do is to adopt some risk-control measures as part of your trading plan.

Two key considerations in this regard are your position size and stop-loss placement. During volatile markets, when daily and day-to-day price swings are generally greater than normal, some traders leverage smaller trades and also use wider stop-losses than they would when markets are calmer. 

The aim of these two fundamental adjustments is to try to avoid getting stopped out due to larger daily price fluctuations while attempting to keep your total level of risk exposure similar to before. Traders also need to note that stop orders can be executed far away from the stop price during a big price gap or over rapidly changing market conditions. 

Unlike long term strategies like growth investing, this approach is much more short-term in execution, meaning that you must set goals and analyse your performance much more closely than in less volatile markets. 

2. Analyse Trends

Although you’re trading in volatility, the best way to give yourself the best chance of success is to pinpoint the individual stocks that are beginning to trend upwards before they’ve reached their peak. In a volatile market, these are often the assets that give you the best opportunity for rapid gains – albeit with some significant risk. 

3. Look to Short Term Accumulation

When there’s less volatility punctuating the market, it’s more logical for investors to take a more long-term approach to investment potential. However, in a more volatile marketplace, it’s important to adopt a more short-term mindset. Set yourself specific profit targets and then sell before profit becomes losses. 

Another strong option is to sell part of the position as soon as you begin making a profit, whilst holding on to the rest in case the stock continues to accumulate value. It may be worth using tighter trailing stops than usual to help facilitate this and protect against deep losses. 

Essentially, the big price swings of a volatile market can be an excellent chance for traders looking to turn their investments into significant rewards in the short term. However, it’s essential that you’re aware of the risks involved to safeguard your portfolio against losses. 

4. Taking Time Away From Your Portfolio may not be a Bad Idea

Although investing in a volatile market can bring significant profit or loss in the short term, it’s important to remember the image regarding the long-term accumulation amidst volatility in the S&P 500. In a market that’s grown 12,577% over time, it means that if you’ve researched the stock you’ve bought and firmly believe in its fundamentals, it could be a good thing to take time away from your portfolio so as to avoid an emotional reaction to instances of volatility. 

The tricky thing for many investors when it comes to managing investments in periods of volatility is timing the market. When looking for trends within volatile stocks, it can be extremely hard to buy market bottoms and to sell market tops – because it’s difficult to know when a top or bottom arrives until after it’s happened. 

If an investor logs into their portfolio to see that a specific volatile stock has shed 4% of its value in a day, this could lead to a panic sell-off when over the next week the stock could trend upwards and accumulate 7% of its value. 

If you’re looking to tap into a volatile market in order to make a cheaper investment in an asset you believe will grow over time, it’s perfectly fine to tap out of your portfolio for a few days or weeks and check back in during more stable times. 

Although there can be some excellent investment opportunities within the buying and selling of volatile stocks, it’s also imperative to remember that investments can go down as well as up, and that this rule is rarely more pertinent than with volatile investments. 

With this in mind, it’s generally a bad idea to jump in both feet first into volatile stocks by investing the majority of your portfolio in more erratic shares. 

Keep your portfolio safe with diversification, and never invest what you can’t afford to lose. At a time when volatility is higher than average in the wake of the Covid-19 pandemic, there can be plenty of risks and opportunities alike for investors to tap into.