Volatility

Financial Dictionary -> Investing -> Volatility

The term volatility is derived from the Latin verb volo, volare which means "to fly". Financial volatility stands for the movement of asset prices for a certain period of time. Volatility is often compared to a roller coaster, as the roller coaster goes up and down with high amplitude. Volatility is the most essential concept in options trading, being a key to the understanding of options` price fluctuation. High volatility inflates the option premium and low volatility deflates the premium. The higher the volatility, the larger the range of price variation and hence, the greater the risk. If volatility is low, prices vary slightly and change in value at a steady pace over a period of time. Stable companies, distinguished by greater degree of predictability, tend to exhibit lower volatility, while companies with more unpredictable behavior tend to have a higher volatility. Further along, volatility does not show the direction of prices, but only their movement. A necessary prerequisite for the construction of risk management models is an examination of the rate of change in asset prices.

Two volatility types can be distinguished: historical and implied volatility. The implied volatility is the standard deviation which forces values, obtained through an option pricing model, to equal the current market price of the option. Implied volatility is sometimes regarded by investors as a forward-looking indicator of market fluctuations.

Historical Volatility refers to a measure of price fluctuation over time. Historical volatility uses daily, weekly, monthly etc. price data to empirically assess the past volatility of a market or an instrument. It is often expressed as a percentage and calculated as the standard deviation per annum with regard to the percentage change in daily prices. Often times, historical volatility is viewed as the best indicator of a movement of a stock.

There are various ways to assess volatility, one of them being the so-called Beta. This instrument is among the most popular models for measuring risk. It is a statistical measure used to determine the volatility of a fund compared to the volatility of its index or its benchmark. A beta that is greater than one suggests greater volatility while a measure of less than one refers to less volatility than the benchmark. In a bear market, one would choose more stable funds which have a beta of less than one, as the funds will probably decline less in value, compared to the overall market in the near future. On the opposite in a bull market, one will invest in stocks or funds with a beta of more than one, thus increasing the chances of beating the market.

In a nutshell, volatility represents a handy measure for decision taking, though overlooked by inexperienced traders.