Extreme Volatility – friend or foe?

Extreme Volatility – friend or foe?

Depending on how you look at it, volatility might be your best friend or your worst enemy.

What is Volatility

According to the financial dictionary, volatility "is a statistical measure of the dispersion of returns for a certain asset or market index."

Plainly said, in the financial market, it means significant swings in either direction. For example, if the stock market rises and falls by more than 1% in a certain period, it is characterized as volatile. Volatility is significant when calculating options prices. When the asset's price fluctuates quickly in a short time, that asset is highly volatile, whereas when a price moves slower, it has low volatility.

What causes Volatility

Usually, volatility occurs as a consequence of imbalanced trade orders. But various reasons can trigger volatility. Let's see some other causes:

a) Health Crises -during periods of health crises, markets are prone to reach their highest volatility, as traders panic-sell assets, causing volatility.

b) Economic Crises –the financial market is highly sensitive to significant events that can affect the economy. Usually, the greater the crisis, the greater its impact on the market's performance.

c) Political Events –speeches from a country's president or a central bank's governor can cause volatility. Also, tariffs, federal spending, or trade agreements can raise a market's volatility.

Types of Volatility

Volatility, amongst other factors, is something that investors are taking into consideration when placing a trade. By extension, there are a couple of types of volatility. To build a robust trading strategy, you have to understand how to "read" the volatility. Now, let's see the kinds of volatility and how traders are using them:

1. Historical Volatility –it is a way of measuring how the returns of a specific asset or index disperse in a certain timeframe. As mentioned before, a risky asset is one that historically has high volatility, but in certain types of trades, both bearish and bullish movements could present a risk. Historical volatility represents a baseline measure because it sets the average price of an asset. With it, traders can ascertain if an asset is overvalued or undervalued.

2. Implied Volatility – reflects the market's sentiment on where it thinks the volatility will be in the future. However, it doesn't predict the direction of the asset's price. Typically, the implied volatility of an asset rises when the market is bearish because investors think that the price will continue to drop. Also, the implied volatility decreases when the market is bullish as traders believe that the cost of an asset will keep on growing. Simpler said the implied volatility is used by traders to estimate upcoming shifts of a price.

How to Trade Volatility

Although it is a concept, or better said, a state of a market, some traders are choosing to invest in volatility, besides the typical investment in stocks, commodities, or currencies. Over time, the concept became an index, commonly known as VIX, short for Chicago Board Options Exchange Market Volatility Index.

The "fear index" or "fear gauge" measures the traders' willingness to buy or sell USA500 options.

Opportunities and Repercussions

A highly volatile market can benefit traders in the long-run, as a portfolio diversification opportunity could be in sight. If you want to know how to diversify your portfolio, have a look at this article. Also, different levels of volatility can make the trader use various investment strategies. Learn all about investment strategies by clicking here. When it comes to short-term trading, if the predicted price direction and volatility are correct, the potential profit can increase.

For investors focusing on momentum trading*, a low level of volatility can be risky, because they are exposed to adverse moves in the markets as they tend to take higher risks. On the other hand, they can make a profit due to the price fluctuations. For example, traders can buy stocks in a company when the price is low and then wait until the price rises to sell.

*Momentum trading: a technique in which investors buy and sell based on price trends. Traders who use this technique believe that the price of an asset that is moving strongly in a direction will keep moving in that direction until it loses strength.

With this concept, there are two sides of the same coin, and it's up to you how you see volatility – as a friend or as a foe. Before you start trading, you need to do research, build, and continuously improve your trading strategies. You can find what you need to know on CAPEX.com in Featured Articles and Market News sections.

Sources: man.com, investopedia.com


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