Volatility is the variation in the trading prices over a period of time that is calculated with the help of standard deviation or variation between returns from the market index. It is important to know that the higher the volatility, the higher there is the risk of security. So, volatility is basically the amount in uncertainty that is related to the size of changes in the value of security.
When there is high volatility, it means that the value of security can be spread over a large range of values. Low volatility means that the value of security does not fluctuate much, and the changes take place in a steady manner over a period of time.
Where a particular stock is concerned, one measure of the relative volatility is the beta that approximates the volatility of returns of security by placing it against the relevant benchmark.
Types of Volatility
Realized Volatility
The first type is the historical volatility that is also known as realized volatility. It is basically observed according to a security’s past price movement. This is a very basic form that sees everyday changes in the stock market.
Relative Volatility
Beta is a measure of relative volatility and is the correlation coefficient of two price series. A value that is greater than 1 means that the stock is moving better than the market, whereas a value less than 1 means that the stock is moving negatively than the market. Negative values mean that the stock price can rise when the market rises and vice versa.
Implied Volatility
This type is the byproduct of an options pricing model and is the market’s expectation of how there might be volatility in the stock prices in the future.
Why Investors Care About Volatility
The price volatility of an instrument can help in determining the position sizing in a portfolio. Furthermore, higher volatility may mean that there are more chances of a shortfall, especially if the cash flow that is acquired by selling a security is needed on a specific date in the future.
Further Reading
- Behavioral finance and its implications for stock-price volatility – www.tandfonline.com [PDF]
- Finance and macroeconomic volatility – www.degruyter.com [PDF]
- Structure and asymptotic theory for multivariate asymmetric conditional volatility – www.tandfonline.com [PDF]
- Estimating stock market volatility using asymmetric GARCH models – www.tandfonline.com [PDF]
- Effect of exchange rate volatility on the Ghana stock exchange – papers.ssrn.com [PDF]
- Asymmetric volatility transmission in international stock markets – www.sciencedirect.com [PDF]
- The impact of cash flow volatility on discretionary investment and the costs of debt and equity financing – www.sciencedirect.com [PDF]
