It can also be defined as a statistical measure of dispersion for particular securities and is measured by variance or standard deviation.
When it comes to option pricing, volatility helps to show the extent to which an underlying asset will fluctuate between the present and the securities expiration. It is usually expressed as a percentage of co-efficient within securities pricing formulas that arises from day trading activities.
In layman terms, it helps to show the range to which the price of an asset may increase or decrease. As said earlier, it is used to indicate the pricing behavior of an asset and helps to provide estimates regarding fluctuations that may occur within a short period of time.
To understand volatility better, think of car insurance premiums. If you have a poor driving record, your premiums will be higher. Why? Your risk level will have risen. In finance, the consequences of volatility result in the rise, fall, rise and fall of the market.
This affects the markets index resulting in traders trying to unload their securities at premium prices.
Digging Deeper Into Volatility
One thing you need to note is that understanding volatility takes on a deeper meaning and relevance. As one of the primary factors that determine the price of a security, it plays a major role on how much a trader will pay to buy a particular option.
Furthermore, it plays a crucial role on how much a trader will receive on selling a particular set of holdings.
Factors that affect volatility include a product launch, earnings report, regulatory ruling and sudden resignation of top management – CEO or CFO of a major company.
When it’s higher, the security’s value will spread out over a large range of values which means its price will change within a short period in either direction. If it’s on the lower side, the value of the security will not fluctuate but the security will experience changes in value at a steady pace.
How to calculate volatility
To arrive at the correct result, you need the historical data of a given stock. It is common for analysts to use one month historical data. In your data sheet, create columns for date, closing price and daily change in percentage of a stock.
The percentage change of your closing price will be calculated by subtracting the previous day price from the current price. This will be divided by the previous day’s price and multiplied by 100. Here is the formula:
Daily % Change = (Current Price – Yesterday’s Price)/Yesterday’s Price * 100
To calculate volatility, you need to get the standard deviation of the daily % change column. If you are using a spreadsheet application, use the following formula:
=STDVA (Cell A: Cell Z)
How to benefit from volatility
Traders can be able to benefit from a volatile market when it’s higher than when it’s lower. If all factors remain the same, a volatile market can be a good incentive for smart investors. Why? It helps to create opportunity.
Day traders do overreact when bad news is provided which creates the opportunity day traders need to make money.
This results in instances where security prices are lower than the value of an investment. To benefit during this period, an investment strategy that is composed of selling put options and covered calls should be set up. This will result in a higher income as well as keeping your portfolio volatility low.
As a trader, one thing you need to note is that volatility can be your friend. For this to happen, you have to manage it well in every stage. This means that risk should be minimized at all times.
Paying attention to market valuation and how far one is into a trade cycle will help you make wise asset allocation. This will not be based on marketing timing but on the analysis of current market valuation.