What is market volatility?
Financially speaking, the term ‘volatility’ can be explained as a statistical measure of the dispersion of returns for a given security or market index. Simply put, the market considered volatile when prices of stocks frequently go up and down by a substantial amount. Bullish traders bid up prices on a good news day, while bearish traders and short-sellers drive prices down on bad news. Market volatility can be seen in any asset class, including stocks, commodities, forex and indices.
In most cases, the higher the volatility, the riskier the security, meaning that its price can change significantly in either direction over a short period of time. Lower volatility, on the other hand, means that a security's value doesn’t fluctuate as much and tends to be more stable.
Volatility shows the security’s pricing behaviour and helps estimate the fluctuations that may happen in a shorter period of time. In simpler terms, it measures how moody the market is or will be in the foreseen future. Volatility is necessary for a stock to be profitable to an investor in the shorter term, such as months or a year. If the price doesn’t fluctuate, it's harder to buy at a bargain and sell at a higher price.
There are a few different ways to measure volatility, including option pricing, standard deviations and beta coefficients. The analysis helps to evaluate the range to which the price of a security may increase or decrease.
Should you be worried about volatility?
It doesn’t matter whether you are a novice or professional, it’s OK if the term “volatility’ terrifies you; it usually makes almost all investors nervous. Most people don’t want to see losses, even on paper.
The human temperament makes it difficult to focus on fundamentals once you see the quoted price of your asset or portfolio swinging wildly. It takes experience and discipline to have the determination to ride through market volatility and capitalise on long-term value creation.
Theoretically speaking, if you are a long-term investor, you shouldn’t be concerned as much since volatility is less influential over a longer time. On the other hand, investors who trade for quick profits should be more careful with volatility as sudden price movements can bring both short-term profits and losses.
So, how can you keep from panicking when market volatility shows up on the horizon? For starters, it’s important to understand that any asset you choose comes with volatility. Every market will always have its ups and downs, and there’s no use trying to predict every step it will make. So, when investing, consider basing your decisions on your timeline and tolerance for risk, rather than on small fluctuations happening in the markets from day to day.
Also, remember that staying diversified is one way to help reduce your exposure to volatility. By spreading your money out over various asset classes you’re also spreading out your risks, as well as ensuring your portfolio’s results aren’t based on the performance of a single investment.
So, how to overcome market volatility?
Market volatility can be beneficial for both investors and traders as it offers an opportunity to profit. Both long and short-term gains can be made if the right strategies are applied timely.
When investing in volatile markets, it is recommended to have a few techniques and tactics hidden in your pocket. The key to success is to prepare in advance. A well-defined investing plan, tailored to an overall financial situation and your personal goals, will help you to be ready for the market volatility and enjoy the price swings.
Here is the list of rules you might want to keep in mind during the times of market volatility:
- Rule 1. Stay cool and be patient. Do what so few investors are capable of: understand that success is a matter of steady progress over time. Successful investors position themselves to benefit from major business themes and economic trends, even if these may take some time to develop.
- Rule 2. Keep an eye on increasing volatility. Modern financial markets have full media coverage, allowing you to stay up-to-date with the latest market news. Additionally, there are a large number of tech indicators and tools that can help you to figure out the current patterns and trends.
- Rule 3. Even long-term winners experience periods of downturns. Even the most stable companies can sometimes see their share prices jumping. To be successful long term, you have to wait through these periods, during which the share price adjusts to the true internal growth rate of the company.
- Rule 4. Remember that the company’s fortunes don’t reverse overnight. Well-managed and robust companies with solid financials and leading market shares don’t suddenly turn sour – even if their share price occasionally swings.
- Rule 5. Good companies do better in hard times, but their stocks take some time to reflect it. Generally, when economic conditions slow, good companies do better than weak ones. Stick with trusted brands, as they have superior management and financial resources to overcome hardships and come out stronger than ever.
- Rule 6. Invest consistently, even during the bad times. Consistent investing can give you the opportunity to buy stocks when they are at their cheapest. Some of the best times to buy stocks have been when things seemed the worst.
- Rule 7. Volatility is a good reason for diversification. There’s no antidote to volatility, but diversification is as close to a wonder drug as there is to hedge the risk.
- Rule 8. At the end of the day, inaction can be the most effective action of all. Sometimes, not taking any radical steps on selling the volatile stock and waiting for the storm to get to an end is the best tactic you can implement.
How to invest in market volatility
There are a number of approaches to trading and investing in a volatile market. Ideally, it is better to search for directional volatility, as it allows you to define the trend patterns. With heightened directional volatility, you will need to ensure your risks are minimised, allowing the profitable trades to outweigh the losses. With a multitude of tech indicators and tools available, you can build a winning trading strategy. To learn more about it, check out trading strategies guide provided by Capital.com.
Typically, there are two ways of trading volatility. Firstly, you can seek out volatility within everyday markets, trading fast moving and high yielding assets.
Secondly, you can trade a volatility product, such as the Volatility Index.
What is the Volatility Index?
The Volatility Index, which is also known as VIX, is a popular real-time market index, quoted in percentage points, which represents the stock market's expectation of 30-day forward-looking volatility implied by S&P 500 Index options. Developed at the request of the Chicago Board Options Exchange (CBOE), it measures how much investors are ready to pay to buy or sell the S&P 500.
Trading the Volatility Index is centred around your perception of forthcoming economic and political uncertainty. In today’s political turbulence, global economic uncertainty and trade disputes, the VIX started to show greater sharp gains.
Whether the VIX might or might not be a solid protection from risk, investors still prefer to keep this indicator on the radar to measure the direction of the attitudes towards the market and the possible path of short-term trading. As a financial indicator in its own right, the VIX can be used as both: the protection of portfolios and a means towards gains.
There are a few ways to add the VIX into your portfolio, including:
Find out what causes volatility in the market with this article. If you want to learn more about the Volatility Index, check out our article on a related topic. Stay up-to-date with the latest market news with Capital.com.