The degree to which the value of a financial instrument changes during a specific period.
What is volatility?
Volatility measures the level of risk associated with the possibility that a stock price will change. More precisely, it measures how much a stock price, or the price of another instrument, changes over time.
Based on the degree of volatility, investors group instruments in two primary categories: high and low volatility. These categories represent the level of risk attached to a specific stock.
High volatility can be a good or bad factor for investors. It indicates an increased risk, since prices can change substantially. Although during periods of high volatility investors can make major losses, volatile prices also provide an opportunity for earning high profits. Investors will often demand a higher return on investment as compensation for uncertainty, because it is more difficult to predict the price.
Low volatility means lower risk levels, because prices are more stable and they may often be predicted with higher degree of certainty. Instruments with low volatility usually have lower returns. Low volatility can indicate stability or lack in demand and supply for a stock. Lack of price swings usually makes it harder for investors and traders to make a profit. Moreover, low volatility can be an indicator of low liquidity for a given stock. Changes in the volume of buyers or sellers can increase volatility.
In their analysis, investors examine different types of volatility.
Historical volatility considers the price fluctuations of the past; this is sometimes referred to as realised or actual volatility. Investors use historical volatility to predict future price movements for a specific instrument.
Implied volatility refers to the volatility level arising from a reference asset. This type of volatility is usually assigned to derivative instruments, such as options. Here, the volatility in the price of the underlying asset affects the price of the derivative instrument. Moreover, implied volatility can come from traders’ expectations about future price movements.
When dealing with volatility, investors have numerous instruments that can limit their exposure to potential losses. They may use a derivative instrument to shield themselves against losses, while making a decent return on their investment in periods of high volatility.