Checklist Description
This checklist provides an overview of price volatility, including some of the factors that can generate rapid gyrations in markets, as well as considering how volatility can, on occasion, present opportunities.
Definition
In a free market, prices are effectively set by the relative levels of supply and demand for the underlying asset. Thus, prices are naturally impacted by rapid changes in the levels of confidence and conviction of market participants, both over short and long terms. Though price fluctuations are part of normal free market activity, at times unexpected major events can have a significant impact on the market’s confidence. During such periods, normal price movements can give way to greater price swings, as market prices gyrate according to the participants’ rapidly changing view of fair value. These price swings are exacerbated in periods of sharp market declines, partly because liquidity can also fall as fewer market participants are willing to attempt to underpin tumbling markets hit by panic selling. In contrast, rising markets typically enjoy higher levels of liquidity, but can, nevertheless, also suffer from rapid price swings, although these are frequently less dramatic in nature than in sudden market slides. Nevertheless, all kinds of market uncertainty can breed volatility.
Though the general concept of volatility is widely understood, in statistical terms volatility represents the relative rate at which the price moves up or down, as defined by the daily price movement’s annualized standard deviation. Thinking in terms of the “bell curve” image associated with the mention of statistical calculations, one standard deviation represents the maximum daily movement we can expect 68% of the time, while the range of two standard deviations should cover 95% of daily net changes. However, it’s important to recognize that by utilizing the input of past data, we are calculating historical volatility. Another way of expressing volatility is implied volatility, which uses the prices of market instruments, such as options, to evaluate investors’ forecasts of future volatility. Though the models developed for options pricing can be highly complex, it is predictable that options prices are likely to be higher at a time of greater perceived uncertainty and elevated volatility, than at other times when investors’ expectations of market conditions are more benign.
Advantages
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Volatility calculations allow comparisons of market conditions during different eras.
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The pricing of derivative instruments, such as options, relies on some form of volatility variable.
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Elevated levels of market volatility can create opportunities for longer-term investors.
Disadvantages
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Volatility-related calculations can be complex, particularly when related to advanced options pricing models.
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High levels of volatility can add to existing levels of market uncertainty, creating a vicious circle for inexperienced market participants.
Action Checklist
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Visualize the basic “bell curve” image of past price movement outcomes to help introduce the concept of volatility to inexperienced investors.
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Acknowledge that volatility in itself is not a guide to market direction, as volatility can move independently of market sentiment.
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Consider how derivative instruments, such as options, caps, and collars, could help you towards your volatility and wider risk management objectives.
Dos and Don’ts
Do
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Recognize the difference between historical (backward-focused) and implied volatility (based on future perceptions).
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Appreciate that volatility isn’t a “bad thing” or a “good thing” as such—it’s part and parcel of free markets.
Don’t
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Don’t waste resources crunching the numbers manually—use spreadsheets or specialized volatility/options pricing packages for calculations.
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Don’t mistake calculations based on historical data as any definitive guide to the market’s future movements—more stocks can be subject to movements beyond the “predicted” standard deviations than the numbers might suggest.
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