FinancialQuotient

What is volatility?

WHAT DOES IT MEAN?

Volatility refers to how fast, and by how much, the price or performance of a financial instrument changes. It typically uses standard deviation to measure how much asset prices or fund performance varies from its mean over a period of time.

For example, the volatility of a stock can be calculated by taking the average of the percentage changes in its daily closing prices over a specific time period, which is then expressed as an annualised percentage. This is known as historical volatility as it is derived from past market prices.

Implied volatility, on the other hand, is a more forward-looking and subjective measure. It is the expected volatility of an asset's price in the future and is derived from the option price of that particular asset.

WHY IS IT IMPORTANT?

Volatility is widely regarded as a key risk indicator of financial assets. An investment with high volatility is considered high risk because its performance may change quickly in either direction at any moment.

Implied volatility also serves as an indicator of market sentiment. For example, the VIX, a measure of the implied volatility of S&P 500 index options over the next 30-day period, is often known as the "fear index" and is a popular barometer for investor perceptions of risk and uncertainty.

A protracted steady rise in stock prices with little day-to-day fluctuations would denote a period of low volatility, reflecting complacency and a lack of fear among investors. However, during a strong market sell-off like the one early last month, volatility often spikes as anxiety rises.

IF YOU WANT TO USE THE TERM, JUST SAY:

"Volatility is a part and parcel of financial markets and results in investment opportunities. Using dollar-cost averaging and having a well-diversified, well-allocated portfolio can help weather market volatility over the long term."

A version of this article appeared in the print edition of The Sunday Times on March 18, 2018, with the headline 'What is volatility?'. Print Edition | Subscribe