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Volatility: Definition, types, and facts
GlossaryWhat is volatility?
Volatility is a financial term that measures the movement of a financial product, such as stocks or ETFs, over a certain period. Volatility indicates the extent to which the price fluctuates. An example of this is a stock that rises by five per cent today and falls by four per cent tomorrow.
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Where does the term come from?
The term ‘volatility’ comes from the Latin ‘volatilis‘, which in turn is derived from ‘volare‘ meaning ‘to fly’. In other words: it is something that changes quickly or is difficult to catch. In the financial world, it describes exactly that behaviour: price fluctuations that go in all directions.
Low volatility vs. high volatility
There is both low and high volatility. Low volatility means that the price is relatively stable and varies little. This is generally considered less risky, which is why you can often say ‘low volatility means calm’. Bonds typically have low volatility, because the value fluctuates less. High volatility, on the other hand, means that the price fluctuates strongly and quickly. This is considered riskier, but also offers the chance of greater profits or losses in the short term. A good example of high volatility is stocks.
What does highly volatile mean?
Highly volatile means that a investment product moves up and down significantly in a short time due to extremely rapid price changes and high trading volume. Suppose the price of a stock rises 10% on Monday and falls 8% on Tuesday – that is highly volatile behaviour. Are you investing in a highly volatile market? Then you will have to deal with large price movements.
What types of volatility are there?
There are several ways to look at volatility. Analysts and investors use different types of volatility to measure or predict movement: historical volatility and implied volatility.
1. Historical volatility
Historical volatility is the actual movement in percentages that a price has had in the past over a certain period. Investors calculate this volatility based on historical price data, often using the standard deviation.
2. Implied volatility
Implied volatility is the expected future movement of option prices. You can therefore speak of future volatility. With options, you speculate on price developments. Option prices rise if the market expects the stock market to show movement, whether positive or negative.
How is it calculated?
Historical volatility is usually calculated using the standard deviation of price movements over a certain period. The standard deviation is a metric that indicates how strongly price movements vary compared to the average. The larger the deviations, the higher the volatility.
To calculate historical volatility, you usually have to use a complicated formula, which requires some mathematical knowledge. However, you can make a rough estimate of volatility by using the following simple formula:
Historical volatility = (highest price − lowest price) / ((highest price + lowest price) / 2)
An example
Suppose you look at the price movements of stock ABC. The closing prices were € 40, € 42, € 36, € 38, € 44, € 41. This means that the historical volatility is the following:
(44 – 36) / ((44 + 36) / 2) = 0.2 (20%)
What is a volatility index?
A volatility index is a measure of the expected movement of the stock market for a certain future period. An example of this is the VIX index. This index gives an indication of the volatility of the American stock market. Another example is the VSTOXX which shows the volatility of the EURO STOXX 50.
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All views, opinions, and analyses in this article should not be read as personal investment advice and individual investors should make their own decisions or seek independent advice. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication.
