Today we have a guest post from Craig Iseli, Spider Rock’s Chief Operating Officer, who answers the question of what volatility is.
Investors take many different factors into account when considering whether to buy or sell stocks, options, and other securities.
The most important is the fundamental value of safety that they are interested in, but they also pay close attention to market behavior using data on how markets have behaved in the past and how they are likely to behave in the future.
Volatility helps investors predict the potential risks and rewards of investing in a security, and it also affects the price of derivatives, which are affected by these factors such as stock options and futures.
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Volatility measures the size of the distribution of the security price over time.
This quantity, also known as dispersion, indicates by how much the price of a security deviates from the mean.
In simple terms, when the price of the security tends to rise and fall significantly around the average price – to swing up or down – the volatility is high. If the price stays close to the mean over time, then the volatility is low.
Volatility is important because high volatility comes with risk.
When a security is less volatile, its price does not have large fluctuations in either direction.
It stays more or less the same over time, gradually increasing or decreasing. In short, it’s more predictable.
It is worth distinguishing between two types of volatility: historical and implied volatility.
Historical volatility measures the volatility of a security in the past. The implied volatility is a forecast of the expected future volatility.
Implied volatility is one of the factors that determine the price of options.
The basic measure of volatility is the standard deviation from the average price, which indicates how the price values are distributed over the average.
- Take the price at intervals over a period of time.
- Calculate the average price.
- Calculate the difference between the mean and each price (the deviation).
- Square these deviations and add them up.
- Divide the total by the number of prizes.
In addition to the standard deviation, there are other more complex measures of volatility that are of interest to investors.
For example, beta measures volatility in relation to the securities market.
The market gets a volatility of 1.0 and the beta of the security measures how much its movement differs from that of the market.
A beta greater than 1.0 indicates higher volatility and is therefore considered riskier, although this approach to measuring risk has limitations and is not useful for long-term risk assessment.
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You may be wondering how investors find out implied volatility – how the price of a security is likely to change in the future.
A common instrument is the Chicago Board Options Exchange Volatility Index, commonly referred to as the VIX.
The VIX is a real-time index of the expected volatility of the market over the next 30 days.
While volatility is a useful and widely used indicator of risk because it is convenient and easy to calculate. However, it should be understood that it is only one of many forms of risk analysis and should be used in conjunction with other factors when making investment decisions.
About the author: Craig Iseli is the Chief Operating Officer of SpiderRock, a SaaS solution for institutional portfolio managers to implement the trading and risk management of systematic multi-asset strategies. Their data products are used by many institutional portfolio managers to improve trading strategies.
Disclaimer: The information above applies to For educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are unfamiliar with exchange-traded options. All readers interested in this strategy should do their own research and seek advice from a licensed financial advisor.