Volatility And Its Types

Volatility has to do with level of fluctuations over a period of time; that is, how ‘wild’ and unpredictable they are.

Volatility is probably one of the most popular words in the finance world. It is used to explain the dispersion of riskiness of an investment. It represents the rate by which the price of an asset or security increases or decreases in relation to its expected returns.

Volatility has to do with level of fluctuations over a period of time; that is, how ‘wild’ and unpredictable they are – and the higher the volatility, the riskier the security is said to be as it becomes less predictable.

Without delving too much into statistical stuff, you can always calculate the volatility of an asset using standard deviations, beta coefficients, and a few other formula. There are a number of types of volatility but we would consider historical volatility, implied volatility, price volatility, and market volatility.

Historical Volatility

Just as we can use a company’s past financial performance to determine its trend and make assertions, the historical volatility of a security is determined based on its past price movements.

This can be determined in relation to time. For example, a 60-day trading volatility calculates the dispersion of the daily loss or gain spanning the period of 60 days on the security.

However, historical volatility typically covers the past year; that is, 12 months. If based on the computations, you determine that the price of the stock has varied or fluctuated over the past year beyond normal levels, it means the stock might not be so attractive because it might take a while before it returns to a good enough price for you to sell at.

Implied Volatility

Implied volatility as the name implies, refers to the form of volatility that is derived from analysis. In other words, it is implied based on computations. It is the form of volatility that is an expression of what the market or options traders expect it to be in the future.

Put simply, it is an estimate of a security's future price movement and where the options prices begins to rise, implied volatility is said to be rising as well all things being the same.

Price Volatility

At the end of the day, price volatility is the way we can define any form of volatility. However, while historical volatility is based on past data and implied volatility is based on computations made in relation to expectations for the future, price volatility is tied to metrics that lead to higher than expected swings in demand and supply – which ultimately affect prices.

The day-to-day percentage difference or changes in the price of the commodity are not just affected by demand and supply. Things like periods, seasons, emotions of the market, unexpected events that take place as well as even the weather plays a key role in this form of volatility.

Market Volatility

Last but not the least is market volatility. It is easy to think of the stock market because the focus is on investment in stocks. However, there are other markets such as the forex market, the commodities market, and so on.

Market volatility, thus, measures dispersion in the prices of securities caused by the overall market the security is a part of. In this situation, the state of the market – whether bullish or bearish – determines the volatility of the security.

These types of volatility represent areas by which the investor can determine the expected/implied risk on his or her investments. They can, as such, guide the investor in making decisions.

Written by Lawretta Egba.