Smart Investor: Volatility, what is it and why it is important

Smart Investor: Volatility, what is it and why it is important

Options 10 minutes to read
Koen Hoorelbeke

Investment and Options Strategist

Summary:  Understanding market volatility is essential for making informed investment decisions and managing risk. This article explains the importance of volatility, its measurement, and its impact on risk assessment, options pricing, portfolio management, and market sentiment, helping investors navigate market fluctuations effectively.


Understanding volatility: The key to smart investing

In the world of investing, understanding market volatility is crucial for making informed decisions and managing risk. Volatility, often perceived as a complex and intimidating concept, plays a central role in determining the behavior of financial markets. This article aims to demystify volatility, explaining its importance, how it is measured, and its current state based on the latest data. By gaining a clear understanding of volatility, investors can better navigate market fluctuations and develop strategies that align with their risk tolerance and investment goals.

What is volatility?

Volatility is a statistical measure of the dispersion of returns for a given security or market index. In simpler terms, it represents the degree of variation in the price of a financial instrument over time. Higher volatility indicates that a security's price can change dramatically over a short period in either direction, while lower volatility suggests that a security's price remains relatively stable. Understanding volatility is crucial for investors and traders alike, as it directly impacts risk assessment, options pricing, portfolio management, market sentiment, and strategic planning.

The importance of volatility

1. Risk assessment

Investors and traders use volatility as a gauge of risk. Higher volatility means higher risk, but also the potential for higher returns. Understanding volatility helps investors decide whether they are comfortable with the level of risk associated with a particular investment. For instance, a highly volatile stock might offer the potential for significant gains, but it also comes with the risk of substantial losses.

Example:

Consider two stocks, A and B:

  • Stock A has a historical volatility of 10%, meaning its price typically fluctuates by 10% per year.
  • Stock B has a historical volatility of 40%, indicating its price can swing by 40% per year.

An investor seeking stability might prefer Stock A, while a more risk-tolerant investor might be attracted to the potential high returns of Stock B.

2. Options pricing

Volatility is a critical component in options pricing models. The most widely used model, the Black-Scholes model, directly incorporates volatility to determine the fair value of an option. Higher volatility typically increases the price of options because the likelihood of significant price swings (and thus the chance of the option ending in-the-money) is higher. This makes understanding volatility essential for options traders.

Example:

Suppose an option with 30 days to expiration has the following prices based on different volatilities:

  • At 20% volatility: Option price is $5.
  • At 40% volatility: Option price is $10.

The doubling of volatility from 20% to 40% results in the option price doubling as well, illustrating the sensitivity of options pricing to changes in volatility.

3. Portfolio management

Volatility is crucial for portfolio management and diversification strategies. Investors seek to balance their portfolios to achieve an optimal mix of risk and return. Understanding the volatility of individual securities and the correlations between them helps in constructing a diversified portfolio that minimizes risk. By spreading investments across assets with varying levels of volatility, investors can reduce the overall risk of their portfolios.

Example:

A portfolio consisting of:

  • 50% Stock A (10% volatility)
  • 50% Stock B (40% volatility)

The overall portfolio volatility will be lower than the average of individual volatilities if the stocks are not perfectly correlated. This demonstrates the benefit of diversification.

4. Market sentiment

Volatility often reflects market sentiment. High volatility can indicate uncertainty and fear among investors, leading to sharp market movements. Conversely, low volatility may suggest complacency or confidence. By monitoring volatility, investors can gain insights into market psychology and adjust their strategies accordingly.

Example:

During the 2008 financial crisis, the VIX spiked to over 80, reflecting extreme fear and uncertainty. In contrast, during periods of economic stability, the VIX typically hovers around 10-20.

5. Strategic planning

For traders, especially those employing short-term strategies, volatility is a key factor in planning trades. High volatility environments may present more trading opportunities due to larger price movements, whereas low volatility may necessitate different strategies, such as range-bound trading. Traders must adapt their approaches based on the prevailing volatility conditions to maximize their chances of success.

Example:

A day trader might look for stocks with daily volatilities of 5% or more to capitalize on intraday price movements, whereas a swing trader might focus on stocks with lower volatilities for more stable, longer-term trends.

Measures of volatility

1. Historical volatility

Historical volatility is calculated based on past price movements over a specific period. It provides an empirical measure of how much the price of a security has fluctuated in the past. This measure helps investors understand the asset's behavior and predict future volatility.

Example:

If a stock's price ranged from $100 to $120 over the past year, its historical volatility might be calculated as 20%.

2. Implied volatility

Implied volatility is derived from the prices of options on the security. It represents the market's expectation of future volatility. Higher implied volatility suggests that the market anticipates larger price movements in the future. This measure is particularly useful for options traders looking to gauge market sentiment and make informed trading decisions.

Example:

If the implied volatility of a stock option is 30%, it means that the market expects the stock price to move by 30% over the life of the option.

3. VIX index: The fear gauge

One of the most well-known measures of market volatility is the VIX, often referred to as the "fear gauge." The VIX measures the market's expectation of 30-day volatility for the S&P 500 index. It is calculated based on the prices of S&P 500 index options and is a widely used indicator of market sentiment.

How the VIX works

The VIX is derived from the prices of near-term S&P 500 options. It reflects the market's expectations for volatility over the next 30 days. When the VIX is high, it indicates that investors expect significant price fluctuations in the near future. Conversely, a low VIX suggests that investors expect relatively stable prices.

Example:
  • During periods of market stability, the VIX might be around 12-15.
  • In times of market stress or uncertainty, the VIX can spike above 30-40.

Other Volatility Indices

Beyond the well-known VIX, there are numerous other volatility indices that provide insights into various aspects of market behavior. Here's a brief description of some of these indices:

  • VIX1D: The 1-Day VIX measures the expected volatility of the S&P 500 index over the next day. It provides a very short-term view of market expectations and is useful for intraday traders.
  • VIX9D: The 9-Day VIX measures the expected volatility of the S&P 500 index over the next nine days. This index captures short-term market sentiment and is often used by traders looking to gauge near-term volatility.
  • VIX: The standard VIX measures the market's expectation of 30-day volatility for the S&P 500 index. It is a widely followed indicator of overall market sentiment and fear.
  • VX1!: The VIX futures index represents the market's expectations of future volatility based on VIX futures contracts. It provides insights into how volatility is expected to evolve over time.
  • ES1!: The E-mini S&P 500 futures index tracks the futures contracts for the S&P 500. It reflects expectations of market volatility and direction based on futures prices.
  • NQ1!: The E-mini Nasdaq 100 futures index tracks the futures contracts for the Nasdaq 100. It provides insights into expected volatility and market direction for technology and growth stocks.
  • VVIX: The VVIX, or Volatility of VIX, measures the expected volatility of the VIX itself. It is an indicator of how much the market expects the VIX to move and reflects uncertainty about future volatility.
  • SKEW: The CBOE Skew Index measures the perceived tail risk of the distribution of S&P 500 returns. Higher values indicate a greater perceived risk of extreme negative returns.
  • COR3M: The 3-Month Correlation Index measures the expected correlation between S&P 500 components over the next three months. It provides insights into the degree of diversification benefit in the market.
  • DSPX: The Dispersion Index measures the expected dispersion of returns among S&P 500 components. Higher dispersion indicates greater differences in performance among the index's constituents, reflecting a more varied market outlook.

Conclusion

Understanding volatility is essential for making informed investment decisions, managing risk, and developing trading strategies. By keeping an eye on volatility, investors can better navigate the complexities of the financial markets. The VIX, in particular, serves as a powerful tool for gauging market sentiment and anticipating future price movements. Whether you're an options trader, a long-term investor, or a short-term trader, a solid grasp of volatility and its implications can enhance your investment approach and improve your chances of success in the financial markets.


Check out these guides and case studies:
In-depth guide to using long-term options for strategic portfolio management  Our specialized resource designed to learn you strategically manage profits and reduce reliance on single (or few) positions within your portfolio using long-term options. This guide is crafted to assist you in understanding and applying long-term options to diversify investments and secure gains while maintaining market exposure.
Case study: using covered calls to enhance portfolio performance  This case study delves into the covered call strategy, where an investor holds a stock and sells call options to generate premium income. The approach offers a balanced method for generating income and managing risk, with protection against minor declines and capped potential gains.
Case study: using protective puts to manage risk  This analysis examines the protective put strategy, where an investor owns a stock and buys put options to safeguard against significant declines. Despite the cost of the premium, this approach offers peace of mind and financial protection, making it ideal for risk-averse investors. 
Case study: using cash-secured puts to acquire stocks at a discount and generate income  This review investigates the cash-secured put strategy, where an investor sells put options while holding enough cash to buy the stock if exercised. This method balances income generation with the potential to acquire stocks at a lower cost, appealing to cautious investors.
Case study: using collars to balance risk and reward This study focuses on the collar strategy, where an investor owns a stock, buys protective puts, and sells call options to balance risk and reward. This cost-neutral approach, achieved by offsetting the cost of puts with the premiums from calls, provides a safety net and additional income, making it suitable for cautious investors. 
Previous "Investing with options" articles
"Saxo Options Talk" podcast
Other related articles
Why options strategies belong in every trader's toolbox
Understanding and calculating the expected move of a stock ETF index 
Understanding Delta - a key guide for Investors and Traders
 

Options are complex, high-risk products and require knowledge, investment experience and, in many applications, high risk acceptance. We recommend that before you invest in options, you inform yourself well about the operation and risks. In Saxo Bank's Terms of Use you will find more information on this in the Important Information Options, Futures, Margin and Deficit Procedure. You can also consult the Essential Information Document of the option you want to invest in on Saxo Bank's website. 

Quarterly Outlook

01 /

  • Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges

    Quarterly Outlook

    Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges

    Althea Spinozzi

    Head of Fixed Income Strategy

  • Equity Outlook: Will lower rates lift all boats in equities?

    Quarterly Outlook

    Equity Outlook: Will lower rates lift all boats in equities?

    Peter Garnry

    Chief Investment Strategist

    After a period of historically high equity index concentration driven by the 'Magnificent Seven' sto...
  • FX Outlook: USD in limbo amid political and policy jitters

    Quarterly Outlook

    FX Outlook: USD in limbo amid political and policy jitters

    Charu Chanana

    Chief Investment Strategist

    As we enter the final quarter of 2024, currency markets are set for heightened turbulence due to US ...
  • Macro Outlook: The US rate cut cycle has begun

    Quarterly Outlook

    Macro Outlook: The US rate cut cycle has begun

    Peter Garnry

    Chief Investment Strategist

    The Fed started the US rate cut cycle in Q3 and in this macro outlook we will explore how the rate c...
  • Commodity Outlook: Gold and silver continue to shine bright

    Quarterly Outlook

    Commodity Outlook: Gold and silver continue to shine bright

    Ole Hansen

    Head of Commodity Strategy

  • FX: Risk-on currencies to surge against havens

    Quarterly Outlook

    FX: Risk-on currencies to surge against havens

    Charu Chanana

    Chief Investment Strategist

    Explore the outlook for USD, AUD, NZD, and EM carry trades as risk-on currencies are set to outperfo...
  • Equities: Are we blowing bubbles again

    Quarterly Outlook

    Equities: Are we blowing bubbles again

    Peter Garnry

    Chief Investment Strategist

    Explore key trends and opportunities in European equities and electrification theme as market dynami...
  • Macro: Sandcastle economics

    Quarterly Outlook

    Macro: Sandcastle economics

    Peter Garnry

    Chief Investment Strategist

    Explore the "two-lane economy," European equities, energy commodities, and the impact of US fiscal p...
  • Bonds: What to do until inflation stabilises

    Quarterly Outlook

    Bonds: What to do until inflation stabilises

    Althea Spinozzi

    Head of Fixed Income Strategy

    Discover strategies for managing bonds as US and European yields remain rangebound due to uncertain ...
  • Commodities: Energy and grains in focus as metals pause

    Quarterly Outlook

    Commodities: Energy and grains in focus as metals pause

    Ole Hansen

    Head of Commodity Strategy

    Energy and grains to shine as metals pause. Discover key trends and market drivers for commodities i...
Disclaimer

Saxo Capital Markets (Australia) Limited prepares and distributes information/research produced within the Saxo Bank Group for informational purposes only. In addition to the disclaimer below, if any general advice is provided, such advice does not take into account your individual objectives, financial situation or needs. You should consider the appropriateness of trading any financial instrument as trading can result in losses that exceed your initial investment. Please refer to our Analysis Disclaimer, and our Financial Services Guide and Product Disclosure Statement. All legal documentation and disclaimers can be found at https://www.home.saxo/en-au/legal/.

The Saxo Bank Group entities each provide execution-only service. Access and use of Saxo News & Research and any Saxo Bank Group website are subject to (i) the Terms of Use; (ii) the full Disclaimer; and (iii) the Risk Warning in addition (where relevant) to the terms governing the use of the website of a member of the Saxo Bank Group.

Saxo News & Research is provided for informational purposes, does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. No representation or warranty is given as to the accuracy or completeness of this information. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. No Saxo Bank Group entity shall be liable for any losses that you may sustain as a result of any investment decision made in reliance on information on Saxo News & Research.

To the extent that any content is construed as investment research, such content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication.

None of the information contained here constitutes an offer to purchase or sell a financial instrument, or to make any investments.Saxo Capital Markets does not take into account your personal investment objectives or financial situation and makes no representation and assumes no liability as to the accuracy or completeness of the information nor for any loss arising from any investment made in reliance of this presentation. Any opinions made are subject to change and may be personal to the author. These may not necessarily reflect the opinion of Saxo Capital Markets or its affiliates.

Please read our disclaimers:
- Full Disclaimer (https://www.home.saxo/en-au/legal/disclaimer/saxo-disclaimer)
- Analysis Disclaimer (https://www.home.saxo/en-au/legal/analysis-disclaimer/saxo-analysis-disclaimer)
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)

Saxo Capital Markets (Australia) Limited
Suite 1, Level 14, 9 Castlereagh St
Sydney NSW 2000
Australia

Contact Saxo

Select region

Australia
Australia

The Saxo trading platform has received numerous awards and recognition. For details of these awards and information on awards visit www.home.saxo/en-au/about-us/awards

Saxo Capital Markets (Australia) Limited ABN 32 110 128 286 AFSL 280372 (‘Saxo’ or ‘Saxo Capital Markets’) is a wholly owned subsidiary of Saxo Bank A/S, headquartered in Denmark. Please refer to our General Business Terms, Financial Services Guide, Product Disclosure Statement and Target Market Determination to consider whether acquiring or continuing to hold financial products is suitable for you, prior to opening an account and investing in a financial product.

Trading in financial instruments carries various risks, and is not suitable for all investors. Please seek expert advice, and always ensure that you fully understand these risks before trading. Saxo Capital Markets does not provide ‘personal’ financial product advice, any information available on this website is ‘general’ in nature and for informational purposes only. Saxo Capital Markets does not take into account an individual’s needs, objectives or financial situation. The Target Market Determination should assist you in determining whether any of the products or services we offer are likely to be consistent with your objectives, financial situation and needs.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the US and other countries. AppStore is a service mark of Apple Inc.

The information or the products and services referred to on this website may be accessed worldwide, however is only intended for distribution to and use by recipients located in countries where such use does not constitute a violation of applicable legislation or regulations. Products and Services offered on this website is not intended for residents of the United States and Japan.

Please click here to view our full disclaimer.