The general reception of cryptocurrency is mixed, to say the least. There is one group hailing it as a new form of currency that could revolutionize finances as we know it. There is another group that looks upon it unfavourably, claiming it is too risky and harmful. For all the disagreements these two sides have with one another, they can agree on one thing. That being the crypto market is incredibly volatile.
Truth be told, it is not just the crypto market. Any market has the capacity to turn volatile.
It is easy to summarize this adjective as an unpredictable change in price for the markets’ assets. In actuality, there is more ground to cover when it comes to volatility. There are also the triggers, the calculations, and the different types that a market may encounter.
‘Volatility’ measures the rate of fluctuations of a security’s price during a specific time span. It is indicative of the level of risk that correlates with the price transformations of a security. Oftentimes, high volatility means that the security is very risky. Volatility’s measurement is either the standard deviation or variance between returns from the security or market index.
In the context of the securities markets, volatility links to huge swings in either direction, be it up or down. Let’s use the stock market as an example. When it rises and falls over 1% during a period of time, it is officially a volatile market. Moreover, the volatility of an asset is an essential factor when it comes to pricing options contracts.
There are three primary triggers of volatility that work by changing supply and demand:
- Seasons. Take the prices of resort hotel rooms for example. They typically surge in the winter when people are looking for a vacation from the snow. In the summer, they drop because people are content enough with travelling close by.
- Weather. The price of agriculture, for instance, heavily depends on the supply. Nice weather will inevitably result in bountiful crops. Hurricanes and other types of extreme weather can boost gas prices, thereby damaging refineries and pipelines.
- Emotions. Panicking traders could potentially aggravate the volatility of whatever they are purchasing. That is primarily why the prices of commodities are incredibly unstable.
Volatility frequently refers to the amount of risk or uncertainty concerning the overall size of security value changes. A higher degree of volatility means that a security’s value can conceivably extend over a wide range of values. From this, the price of the security can alter over a short period of time in either direction. Lower volatility indicates that a security’s value will not experience dramatic fluctuation. Moreover, it is prone to be much more steady.
Quantifying the daily returns (percent daily move) of an asset is one way to measure its variation. Historical volatility draws from historical prices and illustrates the level of variability in an asset’s returns. This number does not have a unit and its depiction comes in the form of a percentage.
It is true that variance, for the most part, captures the dispersal of returns around the mean of an asset. However, volatility measures that variance when it is bounded by a specific time period. Therefore, we are able to report volatility on a daily, weekly, monthly, or annual basis. With that in mind, it is handy to interpret volatility as the annualized standard deviation.
The easiest way to determine a security’s volatility is to gauge its prices’ standard deviation over a period of time. This is achievable by following these steps:
- Round up the past prices of the security.
- Calculate the average price (i.e. the mean) of these past prices.
- Identify the difference between the average price and each price within the set.
- Square the differences you uncover during the previous step.
- Sum the squared differences.
- Divide the squared differences by the number of prices in the set. In other words, figure out the variance.
- Figure out the square root of the number that was acquired in the previous step.
More than one type
Volatility is a concept that has been exhaustively studied, measured, and detailed over the years. This analysis is especially prevalent in the stock market and the crypto space. This intensive research would establish four key types of volatility: historical, market, implied, and stock.
1 – Historical
‘Historical volatility’ is the amount of volatility a stock has during the previous year (12 months). If the stock price was varying widely, it is a lot more volatile and is a bigger risk. The appeal dwindles to a point where it is less attractive than a stock with less volatility. You may have to hold it for a while before the price reverts back to where you can sell it. If you can easily tell that it is at a low point, there is a chance that you will get lucky. You will be able to sell it as soon as it once again gets high.
This is a method known as “timing the market” and when it works properly, it generates great results. Unfortunately, with a volatile stock, it could go downward for an extensive period of time before going back up. One never knows for sure because it is unpredictable.
2 – Market
‘Market volatility’ is the velocity at which a price changes for any kind of market. These include commodities, the stock market, and forex (foreign exchange market). An increase in volatility within the stock market is indicative of a potential market top or market bottom. Evidently, there is a lot of uncertainty here. On a day of good news, bullish traders will bid up prices. On a bad news day, though, bearish traders and short-sellers push prices downward.
3 – Implied
‘Implied volatility’ refers to the amount of volatility that options traders believe the stock will have in the future. Determining the implied volatility of a stock is easy. All it takes is looking at exactly how much the prices of the futures options vary. If the prices start rising, that means the implied volatility is experiencing an increase.
If you are right, the option’s price will increase, which means you can sell it and make a profit. Put simply, someone can sell an option if they believe it will continue to get less volatile.
4 – Stock
For ‘stock volatility’, investors use the “beta” measurement. It notifies how well the stock price correlates with the Standard & Poor’s 500 Index. If it moves harmoniously with the index, the beta will be 1.0. Stocks. Betas that exceed 1.0 are much more volatile than the S&P 500. Stocks that have a beta below 1.0 are not as volatile by comparison.
Economists created this type of measurement due to the prices of some stocks being extremely volatile. That unpredictability transforms the stock into a risky investment. This in turn causes investors to seek out a much higher return for the sudden increase in uncertainty.