Volatility is the degree at which the stock prices shows movement whether by surging or plunging over time. It is demonstrated as a percentage. Volatility shows the range at which stock prices may increase or decrease.
Volatility shows the risk involved in the stock. It is used in derivative formula (option pricing) to measure the movements in the return of the underlying assets. In simple terms, it just shows the behavior of the stocks and due to this market speculators can estimate the movement and build a short-term position in the market and try to make a profit from it.
If the stock prices rush in a short time, it is termed as high volatility, and if stock prices fluctuate slowly, then it is considered low volatility.
Emergence of Volatility
Many research has been committed for modeling and forecasting the financial returns volatility, and yet there are few theoretical models which describe how volatility came into existence. In 1984 Roll shows that volatility gets affected by market microstructure, in 1985 Glosten and Milgrom explains that the liquidity provision process can describe at least one source of volatility.
Investors prospective for Volatility: There are only a few reasons which show that investors care about volatility:
- Volatility in a market or trading instrument can define position size in a portfolio.
- If investors build a short position that means investors are expecting a profit from selling stock, on that higher volatility means a substantial chance of a shortfall.
- Due to volatility investors get opportunities to buy assets undervalued and sell when they become overvalued.
- Volatility affects options pricing, and it can generate certain revenue for the investors.
- Volatility shows a negative impact on the CAGR of the portfolio.
In today’s market, an investor can trade volatility directly, by using derivative securities like options.
Causes of Volatility: There are three factors which cause Price volatility.
- Seasonality: For example, the hotel room prices rise in winter and drops in summer.
- Weather: It is another factor which causes volatility. Example, agricultural prices are bounded by weather. Weather effects crops production and due to that supply can get affected, and this can create massive momentum in the agricultural commodities/stock prices.
- Emotions: It is the third factor, whenever trader get worried, they aggravate the volatility of the stocks. That’s the reason the prices of commodities are so unstable.
Misconception: Volatility does not represent the direction of stock prices. Two instruments with inconsistent volatilities may show the same returns, but the instrument with higher volatility will have more remarkable oscillate in value over a specified period.
Strategies suitable for volatility: Volatility is one of the dominant factors which affects the option pricing, and every investor/trader must be familiar with this term. The Trader must identify the strategy according to the market volatility. If the market is showing high volatility, in that case, Straddle, Bull Put Ladder, Bear Call Ladder strategies are suitable, and if the market shows low volatility in that case Long Iron Butterfly, Long Iron Condor, Bull Call Ladder are suitable. Volatility can apply for making a profit or generating income from that.
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