Volatility is the basic term which comes across whenever somebody is dealing in financial markets. It is considered as a blessing and curse simultaneously for the traders. But, still it is true that without volatility there can’t be any sort of trading. Let us discuss the concept in more detail and understand the importance of volatility in the trading world.
What is Volatility?
Whenever the term volatility comes up, the first thing which comes to mind is choppy markets or large price swings. The literal meaning of volatility is that it is the measure of degree of price movement in a financial movement. It should be noted that it does not measure the trend or the direction of the movement.
It can be said that a volatile market seems like quite a rollercoaster ride. The volatility is measured from the size and speed of these ups and downs the market is experiencing. Price fluctuations occur on a daily basis because of various reasons, to name a few - actions of the company, market or economic shifts, or government decisions etc.
As, the term volatility is widely used, there are two main measures :
When volatility is measured over a sustained period of time keeping in mind the historical movements in stock prices, it is referred to as historical volatility. When there is a rise in historical volatility, a stock’s price will also move more than normal so it will or has changed. If it is dropping, on the other hand, it means any uncertainty has been eliminated, so things may return to the way they were.
As opposed to historical volatility, implied volatility is a projection of movements in the stock prices. It is used to determine where a particular stock’s value is headed without accounting for historical data. Analysts take into account numerous factors to project the likely movement in securities’ prices. However, it does not tell you in which direction prices will move.
Difference between Historical and Implied Volatility
As discussed above the two types of volatility namely Historical and Implied volatility are widely used in the financial markets. It can be concluded from the brief description that both the volatilities are somewhat interrelated.
The main difference between the two is that historical volatility does its analysis based on the past observed prices. Whereas implied volatility tells you the future volatility of the instrument. It can be noted that when implied volatility is high, it means that the market wants the instruments whether it is stock or forex to remain volatile (which means to keep making large moves). While on the other hand if the implied volatility is low, then the market wants the instruments to trade flat.
The Concept of Beta
Beta is a statistical measure which gives a clue as to how volatile a stock can be. It is done by comparing the potential volatility of a particular share to the market in general. The market (as represented by, say, the NIFTY 50) is assigned a beta of “1”.
Any stock with beta greater than 1 is considered more volatile than the rest of the stock market, on the other hand any stock with beta lower than 1 is considered less volatile.
For example, If a stock has a beta of 1.5 it is considered 50% more volatile than the general market. Meanwhile, a stock with a beta of 0.85 is considered 15% less volatile than the general stock market.
It has been said that the investors should not be very terrified of the volatile markets. As it has been in the past, volatile markets represent enormous opportunities if taken advantage of very cleverly. It is always beneficial for investors to do their research properly about the market volatilities and invest during the same cautiously.