Volatility: what drives it, how to navigate volatility in the markets and make it work for you
Volatility can have a large and potentially dramatic impact on your trading. It is a broad term that is used frequently in the financial press and by financial market analysts. It can be used in reference to the options market, specific events and in relation to risk management. At its most basic level, volatility is the rate at which the price of an asset increases or decreases over time. Volatility is incredibly important for traders for two reasons: firstly, it can tell them how much an asset price will move over a period of time and help them to make a choice as to whether they want that asset in their portfolio. Secondly, volatility can indicate how an entire market moves due to external events. We will discuss the various forms of volatility below.
Volatility in all its guises
As we have mentioned, there are many different types of volatility. Option market volatility or implied volatility, market volatility, risk premiums, and portfolio volatility are all worth understanding in detail to try and enhance your chance of successful trading.
1. Implied volatility:
We have ascertained that volatility measures the risk of an asset; this makes volatility important in measuring the price fluctuations in the returns of an option’s underlying asset. Volatility will help you to understand the pricing structure of an asset, and how the price moves in a short period of time. For example, if the price of a security moves rapidly in a short period of time, then it is considered to have a high level of volatility. If the price of an asset doesn’t move too much over a set period of time, then it is considered to have low volatility. It is worth remembering that an option on an underlying asset with high levels of implied volatility usually results in high-priced option premiums, and vice versa for options with low levels of implied volatility.
2. Market volatility:
This is what most people think of when they hear the term volatility, and it is usually the type of volatility that is referred to in the media. When market volatility is high then whole sectors of asset classes can move sharply. In some cases, market volatility can surge to such an extent that nearly every financial market in the world is at risk. This was the case in March 2020, when multiple asset classes were thumped by the spreading coronavirus. Back then stocks slumped, however, the selloff did not stop there. Even some safe havens started to sell off including gold and US Treasuries, as the event risk linked to Covid-19 sparked a mass liquidation event in financial markets. Other instances where market volatility has risen sharply include the financial market crisis of 2008-2009, which saw a particularly sharp selloff for financial stocks and bonds, and the unexpected result of the UK’s European Union referendum in 2016. When it was confirmed that the UK would be leaving the European Union, the pound slumped at its fastest ever rate, and is still struggling to recover from that sell off more than 4-years’ later.
Market volatility can be brutal, but it is usually a short, sharp shock to markets and they then recover. This was the case for some stock market indices after the selloff in March 2020. Stocks hit multi-year lows, however, some markets, including the main US indices, bounced back to record highs in the months after the sell off. Thus, market volatility can create multiple opportunities for traders and should not be something that traders are frightened of.
Luckily, market volatility is measured by special volatility indices. The most famous of these indices is the CBOE’s Vix index, which measures the volatility of the S&P 500. The Vix is considered the global standard for market volatility. Luckily, most trading platforms allow you to trade the Vix index using a CFD or a spread bet. Thus, due to the flexibility of these instruments, you can easily buy and sell market volatility. This can be a useful trading tool for a couple of reasons. Firstly, it can help you to benefit from various market conditions. If you are long the Vix, then you benefit when the Vix index rises, or when market volatility jumps; in contrast, if you think that financial markets will calm down then you can short market volatility to take advantage of the Vix falling. Trading a volatility index can also help you to protect your trading portfolio. For instance, if you have a long position in multiple US or European shares, which are considered risky assets, then you may want some long exposure to the Vix index, just in case market volatility surges and global stock prices sell off. Conversely, if you are long some safe haven bonds, then you may want to take a short position in the Vix at the same time, in case the market collapse that you may be preparing for never happens.
Market volatility is endlessly fascinating, and we would urge anyone trading to always keep an eye on the Vix, usually if it rises above the 15 level then it can indicate that something is going on that could hurt share prices.
3. Risk premiums:
As we have mentioned, volatility is used to calculate risk premiums in the options market. It is also a key driver of the price of most assets, in particular single stocks. If you look at the price of a stock it is constantly moving as supply and demand for the stock fluctuates and this drives the stock price. One input to supply and demand factors can be volatility. For example, sometimes stocks that traditionally have very erratic price movements can be cheaper to buy than stocks that have more predictable price moves. This is because price predictability is considered attractive when forming a portfolio of stocks, as it is easier to predict what your future returns can be.
Thus, stocks with lower levels of volatility, and more predictable returns, can generate more demand than stocks with less price predictability. This is why, on balance, blue chip stocks, which include some of the largest companies with the most consistent returns, can have lower levels of volatility than their smaller counterparts who do not reside in the blue-chip indices.
There are exceptions to this rule. For instance, in March 2020, a little-known company called Zoom saw its stock price soar by more than 800% as the world’s governments started to impose lockdowns to try and supress the coronavirus. As millions of people started to work from home, Zoom’s video conferencing technology was in high demand and its stock price reflected the dramatic and sudden change in its fortunes. This is an example where a high level of price volatility paid off, and Zoom was one of the top performers in the US stock market at the peak of the coronavirus pandemic in Q1 and Q2 2020.
4. Portfolio volatility
When you are trading it is important to look at all of your open trades and try to gauge how exposed you are to volatility. For example, if global stocks tanked tomorrow, would you blow out of your account? The answer is probably yes, if you are long mostly stocks, especially if you have high exposure to “growth” stocks, which tend to do well in market upswings and can be overvalued.
It is important to estimate how exposed you are to volatility, and to address any imbalances. For instance, if you have a lot of exposure to only one sector, or mostly growth stocks, then it may be time to move out of some of your positions to try and balance your portfolio. This was a common concern among some traders in the late summer of 2020. US tech stocks were soaring in popularity after they had a stellar run during the peak of the first wave of the coronavirus crisis.
However, some companies saw their stock market valuations soar to unsustainable levels, for example, Amazon had a price to earnings ratio above 150, at one stage, and there was a similar situation for Apple. Savvy investors could see that these valuations would not last long, and the savviest closed their long positions in these tech companies at the start of September, just as a healthy pullback occurred in the US tech sector.
Don’t ignore volatility
Overall, understanding volatility can help you to ensure that your portfolio remains balanced and that you have a practical risk management strategy in place. Don’t ignore volatility, if you do then you could damage your capital and future profits.