What Is the Best Measure of Stock Price Volatility?

Stock prices aren’t generally bouncing around constantly—there are long periods of not much excitement, followed by short periods with big moves up or down. These moments skew average volatility higher than it actually would be most days. Volatility is also used to price options contracts using models like Black-Scholes or binomial tree models. More volatile underlying assets will translate to higher options premiums because with volatility there is a greater probability that the options will end up in-the-money at expiration.

Often, oil prices also drop as investors worry that global growth will slow. Implied volatility describes how much volatility that options traders think the stock will have in the future. You can tell what the implied volatility of a stock is by looking at how much the futures options prices vary. If the options prices start to rise, that means implied volatility is increasing, all other things being equal. Whether volatility is a good or bad thing depends on what kind of trader you are and what your risk appetite is. For long-term investors, volatility can spell trouble, but for day traders and options traders, volatility often equals trading opportunities.

Standard deviations are important because not only do they tell you how much a value may change, but they also provide a framework for the odds it will happen. Sixty-eight percent of the time, values will be within one standard deviation of the average, 95% of the time they’ll be within two and 99.7% of the time they’ll be within three. Market volatility is the frequency and magnitude of price movements, up or down. The bigger and more frequent the price swings, the more volatile the market is said to be. And there’s always the potential for unpredictable volatility events like the 1987 stock market crash, when the Dow Jones Industrial Average plummeted by 22.6% in a single day.

1. The value of shares and ETFs bought through a share dealing account can fall as well as rise, which could mean getting back less than you originally put in.
2. Many day traders like high-volatility stocks since there are more opportunities for large swings to enter and exit over relatively short periods of time.
3. By the end of the year, your investment would have been up about 65% from its low and 14% from the beginning of the year.
4. Second, investment performance typically exhibits a property known as kurtosis, which means that investment performance exhibits an abnormally large number of positive and/or negative periods of performance.
5. If prices are randomly sampled from a normal distribution, then about 68% of all data values will fall within one standard deviation.
6. It is usually measured as the standard deviation of the asset or index returns, which reflects how much the returns deviate from their average or expected value.

Beta measures a security’s volatility relative to that of the broader market. A beta of 1 means the security has a volatility that mirrors the degree and direction of the market as a whole. If the S&P 500 takes a sharp dip, the stock in question is likely to follow suit and fall by a similar amount.

Learn first. Trade CFDs with virtual money.

But for long-term investors who tend to hold stocks for many years, the day-to-day movements of those stocks hardly matters at all. Volatility is just noise when you allow your investments to compound long into the future. For the entire stock market, the Chicago Board Options Exchange (CBOE) Volatility Index, known as the VIX, is a measure of the expected volatility over the next 30 days.

What is Volatility?

For example, a lower volatility stock may have an expected (average) return of 7%, with annual volatility of 5%. Ignoring compounding effects, this would indicate returns from approximately negative 3% to positive 17% most of the time (19 times out of 20, or 95% via a two standard deviation rule). These estimates assume a normal distribution; in reality stock price movements are found to be leptokurtotic (fat-tailed). Investors can find periods of high volatility to be distressing as prices can swing wildly or fall suddenly.

Grammar Terms You Used to Know, But Forgot

Next in line are corporate stocks and bonds, which are always desirable but with the caveat that some corporations do better than others. Blue-chip corporations historically perform well and yield a positive return, while small-cap, more growth-oriented corporations might have large returns with periods of high volatility. Next, calculate the percent that this moving average has changed over a specified time period. When looking at the broad stock market, there are various ways to measure the average volatility. When looking at beta, since the S&P 500 index has a reference beta of 1, then 1 is also the average volatility of the market.

Although this volatility can present significant investment risk, when correctly harnessed, it can also generate solid returns for shrewd investors. Even when markets fluctuate, crash, or surge, there can be an opportunity. Volatility can be a good thing or a bad thing, depending on the investment goals and strategies of the investor. For short-term traders or speculators, volatility can provide opportunities for quick profits or losses, depending on the direction of the price movement. For long-term investors, volatility can be a source of risk or opportunity, depending on the quality and diversification of the portfolio. Volatility refers to the degree of variation in the price of a financial asset or market index over time.

“When the market is down, pull money from those and wait for the market to rebound before withdrawing from your portfolio,” says Benjamin Offit, CFP, an advisor in Towson, Md. While heightened volatility can be a sign of trouble, it’s all but inevitable in long-term investing—and it may actually be one of the keys to investing success. Assessing the risk of any given path — and mapping out its more hair-raising switchbacks — is how we evaluate and measure volatility. Conversely, a stock with a beta of .9 has historically moved 90% for every 100% move in the underlying index.

Periods when prices fall quickly (a crash) are often followed by prices going down even more, or going up by an unusual amount. Also, a time when prices rise quickly (a possible bubble) may often be followed by prices going up even more, or going down by an unusual amount. If you’re right, the price of the option will increase, and you can sell it for a profit.

Generally speaking, when the VIX rises, the S&P 500 drops, which typically signals a good time to buy stocks. Market volatility can also be seen through the Volatility Index (VIX), a numeric measure of broad market volatility. The VIX was created by the Chicago Board Options Exchange as a measure to gauge the 30-day expected volatility of the U.S. stock market derived from real-time quote prices of S&P 500 call-and-put options. It is effectively a gauge of future bets investors and traders are making on the direction of the markets or individual securities. The VIX—also known as the “fear index”—is the most well-known measure of stock market volatility. It gauges investors’ expectations about the movement of stock prices over the next 30 days based on S&P 500 options trading.

On an absolute basis, investors can look to the CBOE Volatility Index, or VIX. This measures the average volatility of the S&P 500 on a rolling three-month basis. Some traders consider a VIX value greater than 30 to be relatively volatile and under 20 to be a low-volatility environment.

Since price is measured in dollars, a metric that uses dollars squared is not very easy to interpret. Therefore, the standard deviation is calculated by taking the square root of the variance, which brings it back to the same unit of measure as the underlying data set. As the chart illustrates, the use of a histogram allows investors to determine the percent of the time in which the performance of an investment is within, above, or below a given range.

Market volatility is defined as a statistical measure of a stock’s (or other asset’s) deviations from a set benchmark or its own average performance. Loosely translated, that means how likely there is to be a sudden swing or big change in the price of a stock or other financial asset. The volatility of stock prices is thought to be mean-reverting, meaning that periods of high volatility often moderate and periods of low volatility pick up, fluctuating around some long-term mean. One way to measure an asset’s variation is to quantify the daily returns (percent move on a daily basis) of the asset.