Market Volatility Meaning
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.
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- 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 Explained
Market volatility is the frequency and degree of price fluctuations, whether up or down. The standard deviation method is usually used to calculate the volatilityVolatilityVolatility is the rate of fluctuations in the trading price of securities for a specific return. It is the shift of asset prices between a higher value and a lower value over a specific trading period. . The deviation value shows the range within which the underlying asset’sUnderlying Asset'sUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates. 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 instrumentsFinancial InstrumentsFinancial instruments are certain contracts or documents that act as financial assets such as debentures and bonds, receivables, cash deposits, bank balances, swaps, cap, futures, shares, bills of exchange, forwards, FRA or forward rate agreement, etc. to one organization and as a liability to another organization and are solely taken into use for trading purposes. 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.
Market Volatility Index
The CBOE Volatility IndexCBOE Volatility IndexVXN, or the CBOE Nasdaq Volatility Index, predicts the future volatility of the market based on data of the Nasdaq-100 index. Essentially, it takes data from the Nasdaq-100 options to gauge the expected volatility of the upcoming 30 days. (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”Implied Volatility refers to the metric that is used in order to know the likelihood of the changes in the prices of the given security as per the point of view of the market. It is calculated by putting the market price of the option in the Black-Scholes model. as the VIX tracks the options market. The VIX index tracks S & P 500 options trading to determine volatility.
How VIX works
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 investorsInstitutional InvestorsInstitutional investors are entities that pool money from a variety of investors and individuals to create a large sum that is then handed to investment managers who invest it in a variety of assets, shares, and securities. Banks, NBFCs, mutual funds, pension funds, and hedge funds are all examples. 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.
Causes of 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 tariffsTariffsA tariff is levied by a government on the import of goods or services from another country. The charges increase government revenue, restrict trade with other countries, and protect domestic manufacturers from stiff competition., it induces doubt in the market. This is especially true for overseas stocks. Election campaigns also have a similar influence on investors; the trade warTrade WarA trade war occurs when one country raises its tariff on imports, and the other country responds by raising its own tariff to restrict imports. 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 cryptocurrenciesCryptocurrenciesCryptocurrency refers to a technology that acts as a medium for facilitating the conduct of different financial transactions which are safe and secure. It is one of the tradable digital forms of money, allowing the person to send or receive the money from the other party without any help of the third party service. 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.
Frequently Asked Questions (FAQs)
The foreign exchange market trades currencies. They are traded in pairs, one country’s currency against another. When the pairs are in too much demand and short supply, the prices increase. The sudden price rise of the currency amounts to volatility.
Trading when the market is volatile comes with risks. However, it is still very much possible to make a profit from volatility. Investors can profit by selling it when the price goes high and buying it back again when the price reduces.
Investors can handle market volatility by practicing patience. They should not give in and make emotional decisions and stick to their financial goals and long-term investing practices. However, predicting or measuring market volatility can be difficult and, therefore, cautious while making investment decisions.
Stock Market volatility can be both good and bad. It can be good to make profits when prices frequently fluctuate within a day and can push the asset price to new levels and increase its value. However, it comes with the risk of making losses and hence can be bad.
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 IndexVolatility IndexVolatility Index, abbreviated as VIX, gives an indication of the expected volatility in the stock market and is based on S&P 500 index options based on 30 days forward period.
- Implied VolatilityImplied VolatilityImplied Volatility refers to the metric that is used in order to know the likelihood of the changes in the prices of the given security as per the point of view of the market. It is calculated by putting the market price of the option in the Black-Scholes model.
- Realized VolatilityRealized VolatilityRealized volatility assesses variation in possible returns from an investment product by analyzing its historical returns in the previous period. The entity's stock price fluctuations help measure the degree of uncertainty or potential financial loss or gain from investing in a firm.