Market Volatility

The market volatility is the rate at which the price of a security or asset ascends or descends over a given time period. It is usually calculated by estimating the standard deviation of the asset’s annualized returns over the specified period. It reveals the risk associated with security.

The market volatility chart indicates the price behavior and the asset's relationship with the factors causing it. Analyzing price fluctuations of the financial instruments over a period helps in predicting volatilities to some extent. This data allows investors to predict the price action and make informed decisions.

• Market volatility occurs when there are frequent fluctuations in the prices of the assets, especially in a short period.
• Factors such as market sentiments, geopolitical developments, market cycles, company performance, and monetary policy changes can induce market volatility.
• Standard deviation is generally used to measure price fluctuations; however, investors also rely on the VIX index as a market volatility indicator.
• Trading during volatile times can be both good and bad. However, even if the price fluctuations can reward, the factor of risk involved cannot be denied.

Market volatility is the frequency and degree of price fluctuations, whether up or down. The standard deviation method is usually used to calculate the volatility. The deviation value shows the range within which the underlying asset's price may increase or decrease. The greater the standard deviation values, the more the portfolio will fluctuate around its average. The market is said to be more volatile when price movements are larger and more frequent. Stock market volatility is an unavoidable component of investing and should be a factor in any portfolio.

While volatility predominantly depends on the factors of demand and supply, when assets, securities, or financial instruments are high in demand and low in supply, price hikes are common. Suppose the investor community decides to abandon the newly found interest in the asset, and the price decreases. Short-term trading can induce frequent highs and lows in the prices. This results in high volatility in the market.

Volatility might have negative connotations, such as increased risk, stress, uncertainty, or increased market declines. However, it can push the price of the asset to a new high, which invariably increases the value and hence can be positive. Therefore it is merely a statistical measure of a security's or index's price fluctuations. Greater volatility indicates that an index or security's price fluctuations are higher or lower—over shorter periods.

The CBOE Volatility Index (VIX) is the primary tool for measuring market volatility. It provides investors an insight into how professionals in the stock market think about the prevailing conditions. This especially helps short-term traders to know where the market is headed and make use of the situation.

The VIX, previously known as the Chicago Board of Options Exchange (CBOE) Volatility Index, is a financial market volatility indicator. It helps measure market volatility by the opinions of professionals in the field. They do it based on predicting how the S & P 500 index will behave over the next 30 days. It is referred to as "implied volatility" as the VIX tracks the options market. The VIX index tracks S & P 500 options trading to determine volatility. 

The options market can be confusing, but the VIX evaluates volatility by examining strike prices for various puts and calls based on options contracts that expire in one month as well as those that expire on different Fridays in the coming month. The weight of prices determine whether investors believe the S&P 500 index will increase or decrease in value in the near future.

When the VIX index rises, it means that professional investors are reacting to increased price volatility in the S&P 500 and markets in general. When the VIX falls, investors wager those price movements in the S&P 500 will be lower, implying calmer markets and less uncertainty. Investors may interpret a drop in the VIX as a hint that the index is reverting to the mean, indicating that the era of higher volatility is coming to an end. Large institutional investors use S&P 500 options to hedge their portfolios and position themselves as winners regardless of whether the market rises or falls. The VIX index tracks these trades to determine market volatility.

The market volatility chart can be unpredictable, and the reasons that cause changes in the market can be difficult to predict. However, there are a few pointers that have the potential to induce market changes, and they are:

#1 - Monetary policy changes

Governments announcing higher interest rates on bank deposits or an increase in long-term capital gains tax for equities can impact investor decisions. Higher interest rates can compel investors to transfer the investment money to bank accounts. At the same time, investors who want to avoid tax will sell to make profits on the increase in capital gains tax. All these things will impact the stock market negatively. 

#2 - Market cycles

Markets undergo periodical ups and downs. When the prices have been rising for a significant period, investors may want to sell and profit from them. Some even try their hand at short-term trading. Short-term traders especially push the prices up and down when they trade frequently.

#3 - Geopolitical influences

When governments declare strict trade laws, taxes, and tariffs, it induces doubt in the market. This is especially true for overseas stocks. Election campaigns also have a similar influence on investors; the trade war escalation between the U.S. and China in 2018 is a good example of it. Instances such as the war between Ukraine and Russia (2022) can induce a negative reaction from the community and make them refrain from investing in and selling existing stocks, thus causing volatility.

#4 - Market sentiments

Prevailing economic conditions and the news largely influence market sentiment. For example, in the crypto market, when there were rumors that governments were going to ban cryptocurrencies in one country, the effect was seen in other parts of the world as well. As a result, most investors sold their holdings, causing adverse price actions.

#5 - Company ratings

The markets always watch a company's progress closely. When there is negative news about a company's performance, it reflects on the stock prices. An example is the patent lawsuit between Apple Inc and Samsung electronics. When Apple was awarded victory in the case, Samsung shares declined and brought down their valuation by a significant amount. Hence, investors felt concerned about Samsung's smartphone business and withdrew their investment. The reverse can be true too. Suppose Apple and Samsung, instead of a lawsuit, decided to make a new brand. Then the market would buy more of their shares and the associated company shares. This is a positive effect but can be the cause of volatility.

Other factors are emerging in current times, such as automatic artificial intelligence trading, which can affect the volume traded. When AI indulges in latency arbitrage, it can cause volatility due to the sheer amount of racing that is happening. 

Let us look at the following line chart of Castrol India Limited stock to understand the concept better.

Source

As one can observe, the blue line marks the closing prices of the stock. It is clear from the ups and downs that the security is subject to significant volatility because of the inherent nature of the stock market. The price fluctuations can be influenced by a number of factors, such as news related to the company, changes in government policies, sector performance, and more.

One can look at stock charts of other companies, like Apple and Tesla, on the TradingView platform to develop a comprehensive understanding of this concept.

This has been a Guide to Market Volatility and its meaning. Here we explain the causes of market volatility along with detailed explanation. You can learn more from the following articles –

• Volatility Index
• Implied Volatility
• Realized Volatility