Sources of passive income can be bank deposits, investments in securities, affiliate marketing and more. Investing in the stock market is one of the common options for such income. Of course, passive income has financial risks. Is there any way to minimize possible losses and evaluate reliability of investments? It turns out, yes. To do so, a trader needs to know what volatility is.
Volatility – a detailed breakdown of the concept
It is a statistical measure of price volatility. Volatility shows the difference between the highest and lowest price of an asset. It is usually expressed in %. The stock market is often compared to a living organism that is constantly changing and evolving. Experienced investors know that regular volatility analysis helps build a sound trading, investment strategy.
“Volatility is not just the difference between the upper and lower price thresholds. It is an important indicator of the deviation from the trendiness of an asset,” says Otkritie Broker.
Market volatility is traditionally calculated as a “link” to stock indices.
High volatility usually refers to significant downward and upward price fluctuations. Low volatility does not imply significant price fluctuations and is characteristic of “calm” periods of the market, when trend movements are more horizontal.
Another important factor to consider is the influence of the trend on price movements. If the fluctuations are within a relative mathematical minimum, we can talk about low volatility. If they have a significant range even though the market is trending, it is an indication that the situation is unstable and the volatility (volatility) is high. There is no need to talk about risk minimisation in markets with high volatility – the price moves quite unpredictably and its further dynamics are rather difficult to predict.
What is the purpose of volatility indicators?
Price volatility determines the dynamics and speed of change in price values and is needed to predict whether the market will reach certain critical values in the chosen direction. In this case, volatility indicators are measured taking into account the standard deviation range of price indicators – the very risks that can affect the actual price movement.
Examples of Volatility
To understand volatility in the financial market, let’s use the analogy of the sea. During calm periods there are hardly any waves, only small ripples are visible. But when there is a storm, the waves are 2 to 3 metres high. It is the same in the stock market – the greater the fluctuations in asset prices, the higher the volatility (volatility). When the market becomes “calm”, it goes down.
Here is another example. One person buys bread at the same price every day. In six months its price has only changed by 3%. The increase in price has had practically no effect on the budget – the buyer takes the bread from the same shop. A change of up to 3%, which does not affect the budget, indicates little volatility.
The second person spends money on cigarettes. The cost of the product increases by about 5% every month. In just six months cigarettes will increase in price by 30%. This will negatively affect the smoker’s income and indicates an increase in volatility.
What factors influence market volatility
The key factor affecting volatility is the supply/demand balance. When the balance is maintained, developments as predicted by financial analysts, volatility remains low. When the balance is disturbed, there is a spike. For example, due to high demand for the asset. The value will rise sharply and with it the volatility.
The supply/demand balance can break down after a news report is published. For example, a corporation’s financial report turns out to be not at all what was expected. Other factors can also trigger high volatility:
- natural, man-made catastrophe;
- political, economic events;
- Monetary policy of central banks of the USA, Russia, China and other leading countries of the world.
Why is volatility rising?
The value of assets can fluctuate under the influence of:
- Seasonality. For example, in the travel business there is a concept of “high season” and “low season”. For example, stays in Turkey literally go from May to September. And when the low season arrives, they are much less in demand. This has an impact on the Russian market as well. For example, the need for gas and electricity is greater in winter than in the warmer seasons.
- The weather. A striking example is the situation in the grain market. Good weather affects yields. The price changes both in case of oversupply of crops, and in case of shortage.
- Emotions. There have been a number of situations at the oil market where the price of “black gold” changed because of the mood of the entrepreneurs. In 2012, the European countries and the United States have threatened to impose sanctions against Iran. Official Tehran responded to the threats by saying it would close the Strait of Hormuz. Closure of the Strait of Hormuz may have triggered oil shortages worldwide. Despite the fact that the strait was never closed, oil prices soared to $110 due to traders’ fear. Three months later, a barrel of oil was trading at $80 because investors were afraid of an oversupply in the market.
Calculating volatility – how to do it right
The level of variability can be calculated in two ways:
- Absolute value. Analysts look at how many pips a currency pair makes during one session.
- Percentages. The calculation is carried out as a percentage.
To assess risks and develop further financial strategy a number of indicators are used. Most frequently it is ATR, but also so called Bollinger lines and CCI are used.
The ATR or Average True Range shows the amount of variation, and not the deviation from a certain value. To perform the calculation, you need to determine the TR’s true range and then calculate its average value over a certain number of trading periods.
How to track volatility with the VIX Index
A variety of tools can be used to track stock market fluctuations. One of them is the VIX volatility index. It was introduced almost 30 years ago by the Chicago Board Options Exchange. The essence of the indicator comes down to the fact that it reflects the S&P 500 index. This index is based on statistical data on the 500 largest U.S. companies. Therefore, the VIX can confidently be considered indicative when it comes to studying the US market.
Do you know why the VIX is called the “fear index”? Simple – its rise indicates investors fear rising volatility in the S&P 500 in the very near future. And a value of 40-45 indicates real panic in the market.
Another indicator that is traditionally used as an analytical tool for calculating market trends are moving averages. They are used to trace the linear average of the market movements over a chosen period of time. Accordingly, based on the data you can trace the volatility of the market for the time period in question.
The proper use of volatility in stock trading
Let’s move on from theory to practice. How to apply volatility in trading to maximise profits and not go bust? At first glance, it may seem that sharp fluctuations help to make money. Indeed, the difference between buying and selling increases. But you will only make money if you are able to predict future market developments. If the prediction proves to be inaccurate, the risk of serious losses increases as well.
Understanding the principles of volatility can help identify the maximum/minimum price for an asset. When there is no important news, the asset moves on a predictable trajectory. That is, if the value fluctuates within 1% every day, it is unlikely to change by 5-10% over the next couple of days. Usually, “lulls” are replaced by spikes in volatility. This is why many experienced investors and traders prefer to enter the market during downturns.
Finally, we would like to tell you the basic principles of trading with market volatility in mind:
1️⃣ When volatility is low, the order book remains in balance. If trading volume does not change, the price also remains the same. But when sellers/buyers are surging, things can change.
2️⃣ It is not only pointless but also dangerous to enter the market when Volatility is surging. It’s not a good time to buy; you will have to wait for the next downturn.
3️⃣ When volatility rises, new, interesting positions open up. But the risk of loss is also significantly higher.
It is no coincidence that volatility is considered one of financial analysts’ favourite words. Almost no forecast is without it. This indicator can rise sharply on the backdrop of important events. Geopolitical events influence indices and gold, publication of GDP statistics influences stocks. Knowing the pros and cons of volatility, as well as the basics of trading with this indicator in mind, you can plan a competent scheme of work.