We continue our informative articles with another hot topic: understanding volatility.
Volatility is a recurrent concept in the financial markets. You hear about it when you read the morning news browsing through your favorite market analysis or even when you look for new trading opportunities. But how well do you know the mechanisms that set volatility and price fluctuations in motion? What are the major volatility drivers, and why? And most importantly: how can you get yourself better prepared to handle market volatility when it appears?
We’ll help you find your answers to all the above questions.
What is volatility?
Volatility measures the rate of price fluctuations in a market over a specific period. Those assets whose prices change quickly in a tight timeframe are very volatile. On the other hand, those assets whose prices move at a slower pace are low volatility assets.
People perceive volatility as a double-edged sword because spikes in prices are usually associated with higher investment risks. Still, at the same time, they can also generate more significant returns. When volatility is high, the risks and potential rewards are high and vice versa. You should always keep an eye out for volatility before taking any trading decision.
Is volatility a market constant?
Volatility is the status quo (the existing state of affairs), and it has always been since the beginning of the financial markets. The reason why is straightforward enough: there is a myriad of factors that can impact stocks, currencies, indices, bonds, and other global assets. All these different elements cause market shifts leading to price fluctuations and, of course, to volatility.
For example, economic factors, such as monetary policy measures, can affect a country’s economy, potentially creating volatility in the currencies market. Think about the market buzz when the Fed or the Bank of England lowers or raises interest unexpectedly. What happens then? Short answer: volatility kicks in!
News reports, as well as political factors and unforeseen incidents, are primary volatility triggers: the COVID-19 pandemic, the China - U.S trade war, or Brexit, to mention just a few examples. Since traders cannot control, nor predict them regularly, they can only resort to the second-best thing: get themselves ready for volatility.
To understand how investors manage to prepare themselves, we’ll stop for a moment to discuss the two main types of volatility.
Implied volatility and historical volatility
By implied volatility, we understand the estimated degree of volatility (the market forecast) of an asset in the future. However, this concept doesn’t predict the direction of an asset’s price. Still, implied volatility usually goes up in bearish markets, as traders expect prices to continue to fall. In bullish markets, implied volatility drops, as prices will eventually start to increase sometime.
Supply and demand are the main drivers for implied volatility. So, when certain assets are in high demand, prices tend to go up, together with implied volatility. On the opposite, when the demand does not match the supply, implied volatility falls. Additionally, natural disasters or any other type of impactful positive or negative news events can have an influence on implied volatility.
Overall, to a certain degree, implied volatility has the role of measuring the market sentiment*, without establishing the price direction of assets.
*The market sentiment defines the traders' overall mood regarding a particular financial market. The market sentiment can be either bullish (if traders feel positive about what's going to happen) or bearish (if traders are pessimistic about the future).
Traders look at historical volatility to estimate the fluctuations in asset values by measuring their shifts in price over a specific timeframe. In other words, whenever historical volatility increases, prices fluctuate more than usual because the markets see the changes coming. Whenever historical volatility plunges, the markets stabilize.
Calculations for historical volatility generally rely on the change from one closing price to the next. In unique scenarios, they can also analyze extended periods of up to 180 trading days. By comparing the percentage changes over more extended periods, traders can better understand how prices might swing before opening a position.
Both implied, and historical volatility are viable means of attempting to predict price fluctuations in the financial markets. Analysts and experts alike advise to consider them when trading, no matter the group of assets and financial instruments. Also, you can build a resilient and varied trading portfolio to reduce risks further.
How do traders measure volatility?
Technical indicators such as Bollinger Bands or ATR (Average True Range)* are common for measuring volatility and for keeping track of price fluctuations in the markets you’re interested in.
*Are you focused on learning more about trading terminology? Check out our Academy, full of educational materials and resources designed to help you develop suitable trading strategies and gain valuable market information!
Another tool for establishing the volatility levels is the VIX index. Known as the fear index or the volatility index, VIX analyzes the implied volatility of the S&P and predicts the overall price fluctuations for the next 30 days. When VIX is on the rise, traders know that uncertainty will come in the markets, and when VIX is at low readings, they expect calmer waters.
With Capex.com, you can trade the VIX as a standalone financial instrument, or you can trade its derivatives: the S&P 500 index or the stocks included in it (such as Facebook, Amazon, Microsoft, or Apple).
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Sources: Investopedia.com, babypips.com
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