What Is Volatility And Why Does It Matter

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What Is Volatility In The Market Mean?

Actual volatility is the measure of the amount of randomness in an underlying asset at any point in time. Actual volatility is instantaneous and can not be measured. That said, volatility is usually measured along a specified period. This is often referred to as historical or statistical volatility. When it comes to volatility in the stock market that is a little easier to quantify. Read on to learn more.

Volatility 101

lognormal distribution volatility

A lognormal distribution is used to model the distribution of security prices. The reason for that is that stocks cannot have negative prices. The normal distribution is used to model returns since it is possible to lose money from investing.

Standard deviation is the statistic used to measure the amount of variability (randomness) around the mean. Standard deviation is commonly used to measure volatility.

volatility

 

Volatility is expressed in annual terms. For example, let’s say Netflix shares are trading at historical volatility of 54% over the last twenty trading days, what does that really mean?

Generally, there are 252 trading days in a year. To express that in a way that traders would understand, we would take the historical volatility and divide it by the square root of the number of trading days.

(.54/15.87)= 0.034

Now, let’s say that Netflix is trading is trading at $250 per share. Take the stock price and multiply it by .034, which results to 8.50.

In other words, the standard deviation says the stock will trade within a (+/-) $8.50 range. A two standard deviation move would by (+/-) 17.

Theory states that prices should stay within a two standard deviation about 95% of the time. Of course, stocks are notorious for having extreme price moves, as witnessed by black swan events like the 1987 Crash and 2008 Financial Crisis.

How Traders Use Volatility

Knowing what the volatility in a stock is, can be very helpful in terms of your trade preparation. For example, if a stock on average has traded in a $15 range over the last twenty trading days, settingĀ  a $0.50 or $1.00 stop on a trade might be a poor idea. You see, that type of move is so small relative to how the stock trades that your chances of getting stopped out are likely high.

Some traders use volatility for mean-reversion strategies. For example, lets say that a two-standard deviation move in a stock is (+/-) $6 and the stock is trading $9 lower, some traders might buy the stock thinking it will bounce.

That said, volatility is mean-reverting. Periods of high volatility are followed by periods of lower volatility.

vix volatility

Source: Yahoo Finance

The chart above is that of the VIX, the volatility index, and what many market pundits call the fear barometer. When the VIX is high, above 25, the market is fearful and the sentiment is bearish. When VIX is low, 20 and below, sentiment is bullish and the appetite for risk is high.

At the end of the day, you’ll want to know how much a stock will move in order to set profit and loss targets, as well as, position size your trade. That said, standard deviation has its flaws. However, if you know these flaws you’ll be able to work around them.

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