Common ways to measure share price volatility

Is volatility good or bad when trading stocks?

You'd never make a profit from going long or short on a stock if its share price never moved. The fact that prices are always fluid in financial markets creates daily, and even hourly, opportunities for investors and traders. High volatility means that the degree of the price movement has the potential to be sharper than normal. This makes higher-than-average profits possible but may also generate higher-than-average losses.

It takes discipline for investors and traders to take full advantage of volatility. Risk management tools can help manage exposure. Some traders may choose to reduce activity during unusually volatile periods, depending on objectives and risk tolerance.

The most common measures of stock market volatility revealed

Four commonly used measures of volatility are used to gauge the degree of risk and potential loss when buying and selling any publicly listed equity:

Standard deviation

Standard deviation is one common metric used to assess historical volatility. Standard deviation measures how far returns have typically moved away from their average over a selected period. A higher standard deviation means returns have been more widely dispersed historically. A lower standard deviation means returns have been less dispersed historically. That should not be read as a guarantee of future price behaviour. 

Standard deviation is calculated from variance. In simplified terms, variance measures the average squared deviation of periodic returns (such as daily or weekly returns) from their average return. Standard deviation is the square root of that variance. 

One of the biggest criticisms of standard deviation as a measure of volatility in the stock market is that it’s based on historical data and is not forward-looking by nature. In any case, exclusively using standard deviation and historical data to form a basis for potential returns in the future is never a sensible move. That’s because there is no guarantee of the past being replicated. 

Another limitation is that standard deviation treats upside and downside moves in a similar way. For example, a share that rose sharply over a period could show high standard deviation, even though some investors may view upside movement differently from downside risk. Because of this, many investors use other tools that focus specifically on downside risk.

Maximum drawdown

Maximum drawdown measures the largest peak-to-trough (the decline from the highest point to the lowest point of a cycle) fall in a share price or portfolio value over a selected period. It is a downside-risk measure rather than a statistical measure of volatility, although it is often discussed alongside volatility metrics.

There is a simple formula to determine the maximum drawdown value of a share price. Subtract the peak value from the trough - or bottom - value and divide the answer by the peak value.

For argument’s sake, let’s say the trough value was $5 and the peak value was $10. You would take the following calculation:

5 - 10 / 10 = -50%

The larger the maximum drawdown percentage, the more an equity is considered to be volatile. The worst possible maximum drawdown is -100%. In this case, the investment becomes entirely worthless and all capital committed is lost.

A smaller historical drawdown may be relevant for investors focused on capital preservation. However, maximum drawdown is historical and does not show whether future losses will be smaller or larger.

One of the biggest drawbacks of maximum drawdown is that although it accounts for the biggest potential loss before a new peak is achieved, it doesn’t factor in the regularity of losses or the size of any profits.

Beta

Beta measures how sensitive a share's returns have been to movements in a chosen benchmark, often a broad equity index such as the S&P 500. A beta close to 1 suggests the share has historically moved broadly in line with the benchmark. A beta above 1 suggests higher sensitivity to the benchmark, while a beta below 1 suggests lower sensitivity. 

Beta is based on historical returns and depends on the benchmark, timeframe and calculation method used. A lower beta does not make a stock risk-free. Company-specific risk, liquidity, valuation changes and changes in fundamentals may not be fully captured by beta.

Beta is also used in the capital asset pricing model, or CAPM, as a measure of systematic risk. It is commonly estimated as the covariance of the asset's returns with the benchmark's returns divided by the variance of the benchmark's returns.

Cboe Volatility Index (VIX)

The VIX is a widely followed index that reflects the market's expectation of 30-day volatility for the S&P 500, based on S&P 500 index options prices. It does not measure the volatility of a single share, but it can provide a broad signal of expected US equity market volatility.

Disclaimer: Options and other derivatives can be complex and carry significant risks, and are not suitable for all investors.

The VIX is often referred to in the media as a "fear gauge" because it tends to rise when investors expect larger short-term market swings. Higher VIX levels are often associated with elevated expected volatility, but the index does not predict market direction and there is no fixed threshold that guarantees a market outcome. 

VIX has spiked above 70 during extreme stress in the past; levels above ~30 are often interpreted by commentators as elevated volatility, but there is no hard threshold.

How to manage volatility in an equities portfolio

One of the options you have to curb the impact of volatility on the equities in your portfolio is to diversify the asset classes you invest in. Government bonds and equities have sometimes moved in different directions, but correlations can change, including during inflationary periods, so bonds may not always offset equity losses.

Some investors adjust allocations as their risk tolerance, time horizon or objectives change. Asset allocation choices depend on individual circumstances. Always remember that higher-risk holdings can increase gains, but they can also increase losses.

The inflationary climate will also influence your choice of bonds. In times of high inflation, it’s possible that low-risk, low-return bonds do not even keep pace with inflation, thereby eating into your portfolio’s purchasing power.

Ultimately, volatility cannot be avoided entirely. Diversification, position sizing and regular portfolio reviews can help investors understand and manage exposure, but they do not guarantee protection from losses.

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