DEFINITION
Volatilityis a measure of the frequency and amount of price fluctuations. It measures the amount of volatility and the frequency with which prices move up or down.
Prices Volatility: Causes and Effects
Three factors are responsible for price volatility. These factors change supply and demand.
Seasonality
Seasonality is the first factor. In the winter months, for example, the prices of resort hotel rooms rise when people are trying to escape the snow. In the summer when people are happy to stay close by, prices drop. This is a good example of seasonal fluctuations in prices and demand.
Weather
Weather is another factor that affects price volatility. Agricultural prices, for example, are affected by the availability. This depends on weather conditions that are favorable for abundant crops. The destruction of refineries and pipelines by extreme weather events, like hurricanes, can cause gas prices to skyrocket.
Emotions
Emotions are a third factor. Worrying traders increase the volatility of what they buy. This is why commodities prices are so volatile.
Note:
Gas prices can be high because traders are emotionally unstable.
In February 2012, for example, the United States, Europe and other countries threatened to impose sanctions on Iran because it was developing weapons-grade Uranium. Iran responded by threatening to close the Straits of Hormuz and potentially reduce oil supply. Oil prices increased to $110 even though oil supply did not change.
Stock Volatility
Investors developed a measure of stock volatility known as beta. The beta tells you the correlation between the Standard & Poor 500 Index and the stock price. The beta is 1.0 if it moves in perfect sync with the index. Stocks that have betas higher than 1.0 will be more volatile than S&P 500. Stocks that have a beta below 1.0 are less volatile. 4
This measure was developed by economists because some stocks’ prices are very volatile. 5 The unpredictability of the stock makes it a riskier investment. Investors want to get a better return in exchange for increased uncertainty.
Volatility in the Historical Record
It is riskier and more volatile if the stock price has fluctuated widely over the last year. This stock becomes less appealing than one that is less volatile. It may take a while before you are able to sell it at a profit. If you can see the chart, and you know it is at a low, you may be lucky enough to be able sell it once it reaches a high point.
It’s called “timing the market” and it is great when it works. A highly volatile stock could go lower for a very long time before going up again. It’s impossible to predict because it is unpredictable.
Implied Volatility
The implied volatility is the amount of volatility that option traders believe the stock will experience in the future. By comparing the prices of futures options, you can determine the implied volatility. All other things equal, if the prices of options start to increase, implied volatility will be increasing.
Note:
How can this information be used to your advantage. If you believe that a stock will become more volatile, buy an option.
If you are right, you will be able to sell the option at a profit if you were correct. If you believe that the price of an option will decrease, then sell it.
Market Volatility
The volatility of a market is its price change velocity. This includes commodities, forex and the stock exchange. Stock market volatility is usually an indication of a nearing market top or bottom. Uncertainty is high. On a day of good news, bullish traders will bid up the price. Bearish traders and short sellers will drive down prices on days of bad news.
Note:
The Volatility Index (VIX) measures implied volatility in the S&P 500.
The VIX is based on stock index options prices. It was created by the Chicago Board Options Exchange in 1993. It gauges investor sentiment.7
The VIX index is also known as the fear index. Stock prices drop when the VIX is elevated. Oil Prices often fall as well, due to investors’ concerns about a slowing global economy. Gold and Treasury bills are sought after by traders looking for a secure haven. This lowers interest rates.
