Stock market volatility is arguably one of the most misunderstood concepts in investing, especially for new investors trying to dip their toes in.
Put simply, stock market volatility is a term used to describe fluctuations in the market, which may refer to factors like stock prices, the volume of trading or the amount of investors participating in the market.
There are various types of volatility and different ways to categorise them. Sometimes, volatility may refer to changes within a certain asset, like a stock or commodity, while other times, it may refer to a specific benchmark, such as the S&P 500 index.
For those looking to differentiate, here are the five common types of market volatility that most investors encounter during their investment journeys.
Price volatility simply means the degree of change in the price of a stock, or asset over time. Some investments demonstrate a high degree of change, sometimes over a short period of time, indicating high price volatility. Others remain relatively stable and may demonstrate a low degree of change over time, indicating low price volatility.
Investment opportunities with a high price volatility can deliver a higher return on investment (ROI) faster than investing in low price volatility opportunities, however, the higher the volatility, the riskier the investment tends to be.
The supply and demand of a company, service or industry can also impact an asset’s price volatility. This can often be based on a few factors including seasonality, weather, major economic events and investor emotions.
To calculate the associated risk, analysts often use the average range of prices over a period of time and display it as a percentage of the asset’s price.
For example, an asset that has average volatility of five per cent is considered more volatile than one that has average volatility of one per cent.
Some stocks are highly volatile by nature. When determining its volatility, it’s common to compare it to a known benchmark, or popular index such as the S&P 500, producing a score known as a ‘beta’.
If the score is 1, it means that the stock’s volatility is identical to that of the benchmark. If it is higher than 1, the asset is more volatile. If it is lower, it is less volatile.
Many investors often want a higher return for their increased uncertainty. Companies whose stock is very volatile must grow profitably and show a steep increase in earnings and stock prices over time in order to pay the investors high dividends or generate returns instead of losses.
As the title suggests, historical volatility refers to the past performance of an asset.
Generally, the stock is assessed for 12 months or more to determine its level of volatility. The stock is more volatile and riskier if the price is more varied in the past year, and as a result, these stocks are often less attractive to investors.
To drive a profit from a buy position, investors have to buy a stock at a low price and hold it until they can sell at a higher price. For volatile stocks, this can be unpredictable – and this method is often referred to as ‘timing the market’.
While past performance is never an indicator of future results, knowing an asset’s historical low and high points can serve as a factor in gauging its stability, and risk, in both the short and long term.
Implied volatility is calculated using the actions of options traders, meaning this volatility is based on sentiment and speculation. By analysing the nature of options placed, it gives an indication of how investors believe a certain asset will behave in the future. Although not entirely accurate, this method also gives some insight into the overall volatility investors believe the asset will display.
Generally, an asset’s implied volatility rises in a bear market, as most investors predict that its price will continue to drop over time. Volatility often decreases in a bull market since investors believe that the price will rise over time. This is down to the belief that bear markets are inherently riskier, compared to bullish markets.
As opposed to price volatility, this kind of volatility relates to the market as a whole, including forex, the stock market, and commodities. Increased volatility of the stock market is generally a sign that a market top or market bottom is at hand.
For example, the VIX index is based on the aforementioned implied volatility, but instead of relating to one specific asset, it gauges the volatility of the Wall Street stock market in its entirety.
By understanding and looking out for various elements of volatility, investors can reduce the amount of risk they expose their portfolios to, while also improving their ability to capitalise on market swings.
As ever, one way to ride out market volatility is to hold investments for the long term. This strategy can help investors absorb any market shocks, like we have seen this year, induced by the coronavirus pandemic.