Volatility

Volatility is an important term for those who want to understand the modern trading market. Basic knowledge in investing is needed not only for the investor, but also for ordinary people.

Volatility is a term that reflects the rise/decline in prices for various assets. High volatility is generally considered a deviation of more than 10% from the average price, and low volatility a deviation of around 1–2%.

If the volatility is low, then the trader simply will not be able to earn much, this is a very important market indicator. With low volatility, non-professional investors can invest relatively calmly. If the volatility is high, the number of transactions increases, as well as the risks and possible profits.

Why Does Volatility Happen?

The reasons can be both external and internal.

1. Internal — traders may influence market fluctuations themselves to make money on price swings.
2. External — political changes, wars, shortages of various resources.

High volatility can trigger a domino effect, which may be amplified by artificially controlled events. Stocks are falling — stockholders are selling them, stocks are rising in price — investors are investing in more expensive assets.

Take, for example, the famous events of 2020. Toilet paper was simply being swept off the shelves in all countries, the price of it was rising, and the shelves were empty. This led to panic — more and more people were buying paper at an increasing cost for it. Although there was no fundamental reason for such frenzied demand.

A professional trader uses volatility to his advantage — buying an asset at a minimum and selling it at a maximum.

How To Calculate Volatility. Types of Volatility

This indicator is usually calculated as a percentage for a certain period of time (day, month, and year). These calculations depend on which positions, long or short, a certain market participant is trading. Annual calculations are extremely important for analytics, to understand the average values of assets.

The following types of volatility are distinguished:

• Historical volatility — a value equal to the standard deviation of the profitability of a financial instrument over a certain period of time, calculated on the basis of historical data on its value.
• Expected volatility — a value calculated from the current value of a financial instrument, assuming that its market value will reflect expected risks.

It depends on the following factors:

• Historical volatility.
• Political and economic situation (elections in the country, announcement of economic indicators, etc.).
• Market liquidity.
• Changing technical levels.
• Even the day of the week.

Historical expected volatility and predictive expected volatility are related measures, providing context for analyzing trends and forecasting future fluctuations.

Which Assets May Be Subject To Volatility

Theoretically, any asset is subject to volatility. In practice, a fundamental rule applies — the higher the yield that an asset promises, the higher the risk of volatility will be. Bonds are considered to be the least volatile assets. Then there are stocks of stable, large companies that have been on the market for quite a long time. Stocks of high-tech young companies are typically more volatile. The riskiest assets include crypto and derivatives, whose exchange rates are highly susceptible to significant fluctuations.

Volatility for the Investor

There are two strategies for investing: long-term and short-term ones. Non-professionals choose the first one, as for them it is an opportunity to preserve savings and make a profit exceeding the inflation rate. Non-professionals often fall victim to volatility, buying securities at the peak and selling them during drawdowns. In order not to lose money, it is necessary to do the opposite. Preference should be given to securities with low volatility, as they are the ones most likely to preserve capital in the long term.

An investor can protect himself from volatility in two ways:

• Hedge risks using various tools.
• Diversify the portfolio by acquiring assets with varying degrees of volatility.

How to Use Volatility to Your Advantage

Predict the movement of asset prices correctly. It is not advisable for a layman to enter the market during high volatility or to immediately trade high-volatility assets.

High volatility will have a maximum impact on short-term investments and a minimal impact on long-term ones.