What is Market Volatility?
Market volatility, where stock prices move up and down significantly and unpredictably, can appear scary to the uninitiated, but professional traders welcome it as an opportunity to buy stocks cheaply or sell high. Here, learn what market volatility is and how it can create opportunities.
Stock-market volatility measures the extent to which the price of a market or a stock moves above or below its annualised average price over a given period. If the price swings wildly in a short period of time, hitting new highs or lows, it is said to have high volatility. If the price changes more slowly, or is relatively stable, it is reported to have low volatility.
High volatility is an indication that investors are nervous about the outlook for the market or a particular stock and so are unsure what price to pay. Standard deviation, or how far a set of data varies from its overall average, is the most common way to measure volatility.
We’ve all seen news reports on TV announcing sharp falls in stock markets, with pictures of worried traders staring at their screens. In reality, these events generally prove short-lived and prices usually stabilise a few days or weeks later.
Even the most extreme market falls, such as those that occurred after 9/11 or during the global financial crisis of 2008–09, appear much less significant when looking at long-term charts of historic stock-market prices.
Volatility creates opportunities
Traders often welcome periods of market volatility as an opportunity to make profits. This is because when events such as those described above occur, some investors panic and sell stocks that may not be particularly affected by the event – making it possible for smart traders to pick up stocks in excellent businesses with strong profit growth relatively cheaply.
Equally, there may be periods when stock prices rise strongly and some investors become over-confident, buying stocks at prices that are not justified by the strength of the underlying businesses. This may be an opportunity to sell stocks and bank profits because it is likely that prices will eventually fall back to more accurately reflect the companies’ profitability and potential.
If you’re a long-term investor, the best approach during periods of volatility may often be to do nothing and simply wait for the storm to blow over.
How to measure and forecast volatility
The Volatility Index, usually called the VIX Index, is the most commonly used gauge of volatility. It measures expected volatility over the next 30 days, in terms of standard deviation, and is sometimes referred to in the press as the ‘Fear Index’, because it is seen as a good way of measuring whether investors are fearful or not about the market’s short-term outlook.
Causes of volatility
Market volatility is caused by unexpected events, reflecting the old cliché that markets hate uncertainty. People generally buy or sell a stock after analysing whether its price is an accurate reflection of the business’s profitability and outlook. But an unexpected event can render those calculations obsolete.
Investors become unsure how the business will fare in this new environment. So, while they are rapidly recalculating their expectations for the business, the stock price is likely to swing wildly until a consensus is reached. These actions are repeated across a market when an extreme event, such as the global economic crisis, occurs.
Other news may affect a particular sector, or even just one stock. There are many events that can prompt stock or general market volatility, so professional investors constantly monitor the news. In a globalised world, even data from the other side of the world can impact on a market.
Suppose, for example, the US government released figures showing that inflation rose at a faster rate than expected during the previous month. That would mean interest rates might have to rise sooner and more quickly than expected, causing investors to reassess their outlook for the global economy.
Alternatively, a company could report an unexpectedly sharp rise in profit growth. This would have a positive impact on the company’s share price, since it could mean that future profits have the potential to grow much faster than was assumed. Moreover, investors may reassess their forecasts for the profit growth of other companies in the same sector because they too might benefit from the factors that caused profits to surge at the original company.
Political events, ranging from an unexpected election result or a hike in taxes on company profits, can also prompt volatility. Natural disasters are another threat. An earthquake in a key oil-producing area, for example, could cause oil prices to spike, with all the implications that has for consumers around the globe.
WARNING: We cannot tell you if any form of investing is right for you. Depending on your choice of investment your capital can be at risk and you may get back less than originally paid in.
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Anthony is a BBC-trained journalist. He has worked in financial services and specialised in investments for over 20 years, writing for various wealth managers and leading news titles. Read more