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In one of our previous article, we talked about risk management and the importance of β. In that article, we used the word ‘volatility’ while discussing β. In this article, we would discuss volatility. We often come across this word in the finance world where we hear people complaining that the “market is volatile”, “the stock is highly volatile”, and so on. So what is volatility?
Volatility:
Volatility is a statistical tool which helps in identifying the swing in the price of an asset class around the mean price. Volatility tells you about the dispersion of the return of any stock or an index from the mean position. Statisticians, use tools like standard deviation and variance to measure volatility.
In finance, we use the beta coefficient, the CAPM model to measure volatility. Volatility is directly linked to risk. In case, there is a larger swing in the price of the asset from its mean price, then that asset is riskier, or we say that the asset is more volatile.
How to evaluate volatility?
Calculation of volatility is simple. You need to follow five simple steps, and you will get the result.
Step 1: Extract the monthly adjusted closing price of any stock, say A. Calculate the % return of the stock from its previous day and calculate the mean.
Step 2: Now, subtract the mean from the closing price of each day. Thus, you get the deviation. While subtracting the mean value from the closing price, you would find some negative value as well.
Step 3: Remove the negative value by squaring the deviation.
Step 4: Sum up the squares of the deviation.
Step 5: Divide the number obtained by the total number of values to get the variance
Step 6: Calculate the square root of the variance to get the daily standard deviation.
This number is a measurement of risk, and it reveals the extent the value spreads around its mean price.
Other than the standard deviation, we can also measure the relative volatility of the stock using β, which we already discussed in the previous article and even provided the steps to measure the same. Beta helps in deriving the overall volatility of the stock as compared to its relevant benchmark index.
Beta value of the market is 1. In case the beta of any stock is 1.1, then it means that if the index moves up by 100%, then the stock would give a return of 110%. On the other hand, if the beta of any stock is 0.9, then it means that when the index delivers a return of 100%, then the stock would provide a return of 90%.
The stock with a beta above 1 is more volatile than the one with beta less than 1. Higher beta stocks are more risker than the stock with lower beta value.
High beta stocks are like double edged swords, provide better returns when the market is doing well. In case the market is not doing well, then these stocks would result in huge losses as well.
Another way to access market volatility is through the volatility index, which in short is known as VIX. The volatility index is the real-time index that gives investors, financial media, researchers, as well as the economists an understanding of the investor sentiment along with the expected level of market volatility.
In the midst of the global coronavirus pandemic fears, the S&P/ASX 200 VIX Index (XVI) has shot up from 12.007 (19 February 2020) to 42.339 (as on 13 March 2020) to make new multiyear highs.
Source: ASX
Volatility index at a relatively higher level gives the investor an indication of large changes in the benchmark index in the next 30 days. In such a scenario, investor sentiment is seeming to be uncertain
On the other hand, relatively lower volatility index indicates that the market expects a very less change in the next 30 days. Investors in such a case have a greater confidence level.
Types of Volatility:
There are five types of volatility:
Price Volatility:
Certain products exhibit price volatility due to factors influenced by the demand and supply dynamics. The fluctuation in demand and supply could be because of change in the season, weather as well as emotions.
Stock Volatility:
There are some stocks whose prices are highly volatile. The price of such stocks is highly unpredictable. Thus, investing in such stocks could be a risky business.
Historical volatility:
Historical volatility tells investors the volatility of the stock over a certain time frame. It could be 6 months, 1 year, 3 years, 5 years or could be any time frame selected by the individual.
Implied Volatility:
Implied volatility predicts the extent of volatility that the stock would have in future. Implied volatility is popular amongst the option traders who use this technique to know how much the price of the futures options will fluctuate. An increase in the option prices gives an indication that implied volatility is increasing.
Market Volatility:
It refers to the speed at which there is a change in the prices of the selected asset class.
Factors Affecting Volatility:
Economic Growth:
The economic growth of a country has a direct relationship with the market volatility. In the case of higher economic growth or where there is a scope of higher growth, the demand & the supply of the goods increases. It helps the companies to improve their revenue, make a profit and provide a dividend to its shareholders. Better results promote an increase in the share price of the stock of those companies.
Interest Rates:
Interest rate also impacts the market volatility. Lower interest rate helps the companies to make more profit. Thus, making the stock of the company look more attractive. Investors get more attracted towards investing in shares instead of any government bond or less risky assets.
Stability:
By stability, we mean the nation’s stability. Any occurrence of uneven circumstances, natural calamity, political instability or terrorist attacks directly impact the stock market, which in turn influences the market volatility. In such cases, one can notice an increase in the prices of goods like oil and gas. Currently, the global stability is out of balance due to coronavirus pandemic.
Investor Sentiment:
Investor sentiment plays a key role in influencing the market. A piece of positive news influences the investors and promote them to buy shares of the company and vice versa.
Bandwagon Effect:
The Bandwagon effect is another factor that influences the market. In the case of the Bandwagon Effect, the investors tend to follow the other investors in the market. In such a case, even if the investor does not intend to buy or sell any stock, still he will do so as other investors in the market are.
PE ratio:
PE ratio of any stock also impacts the long-term performance of the shares. PE ratio is often used as a relative tool to identify if the stock is overvalued or undervalued. In case the price of the stock is increasing above its historical average, then it indicates that the stock has become overvalued. In case the stock becomes overvalued, investors do not prefer to buy such stocks. Typically, high PE stocks are more volatile than low PE stocks.
Understanding volatility helps an investor to build a portfolio keeping the return and risk profile in check. High volatility could be used to benefit a investor and that is certainly based on how one is able to position the overall portfolio. Thus, portfolio diversification is often suggested for mitigating volatility.
