What is Volatility? Definition and types

Volatility

Volatility is used in option pricing formulas to gauge the fluctuations in the returns of the underlying assets. Therefore, it helps measure the risk of a security. It indicates the pricing behavior of the security and helps estimate the fluctuations that may happen in a short period of time.

• If the price of a security fluctuates in a short time span, it is termed to have high volatility.
• If the price of a security fluctuates slowly over a longer time span, it is termed to have low volatility.

How Does Market Volatility Affect Trader Sentiment?

“Volatility is the friend of the value investor” Tweedy, Browne Co.

An integral part of financial data analysis is analysing market sentiment. The prices of assets  traded on the market will move dynamically on a daily basis. This is a natural effect of the stochastic behaviour of the financial market. However, the high risk nature of the market doesn’t deter investors from investing in the market to gain profits in the future. High uncertainty can either lead to huge losses of massive gains.

If the volatility is too high, some investors may not invest in the market, whereas others would engage in trading with the hope to achieve higher profits. In the stock market context, rapid price fluctuation in either direction is considered as volatility. Therefore, a high standard deviation value means prices can dynamically rise or fall and vice versa. In most cases, a surge or dive of 1% in market indexes classifies it as a volatile market.

Factors Affecting Volatility

A number of factors affect market volatility such as: 

• Supply and demand for securities
• Geopolitical factors prevalent in an economy
• Socioeconomic factors
• Expiration date of an options contract

It is important to remember that a volatile market does not always mean that the investor will face heavy losses. It’s just a high-risk situation, which can be leveraged by investors in their own favour. Making timely use of options contracts to make gains or hedge their portfolio against downsides will help gauge the risks presented by high volatility.

Volatility is a multi-faceted measurement.

Historical Volatility

Historical volatility refers to the measurement of volatility over a sustained period based on historical movements in returns or prices. Historical volatility is also known as statistical volatility due to its heavy reliance on scientific measures.

Historical volatility helps determine a security’s performance in the past based on its underlying asset’s price movements over different periods. 

When the prices of accounted securities fluctuate at a greater scale, the historical volatility rises. On the other hand, when prices witness low-scale deviation from the mean or average, the statistical volatility will fail.

Implied Volatility

Unlike  historical volatility, implied volatility is a future projection of probable movements in values of securities.

Implied volatility helps determine the future of a particular stock’s value, without taking into account its historical data. This is an essential metric that helps determine the prices of options contracts. Implied volatility is expressed in percentages, however, it does not clarify the direction in which prices will move.

• A high implied volatility suggests that the price of a specific security will change dramatically -- it could either appreciate or depreciate in value. 
• On the other hand, a low implied volatility suggests that the price of a specific security  will not change dramatically, apart from minor deviations. 

Therefore, a bearish market will show a high implied volatility rate in comparison to a bullish market, where implied volatility will be low. This is because in a bearish market, the prices are predicted to decline over time, whereas in a bullish market, the prices are expected to increase over time. 

Implied Volatility and Options Contracts

As we know, there are two types of options contracts: call option and put option. In a call option, an investor is entitled to purchase stocks at a strike price within the contract’s expiration date. Whereas, in a put option, an investor is entitled to sell stocks at a strike price within the contract’s expiration date. 

Implied volatility of the underlying security is used to price options contracts. One of the most used models for options contracts is the Black-Scholes model which takes into account the IV of an underlying asset, its current market price, its strike price, and the date of expiration to determine its price. 

Different Measures of Volatility

Volatility can also be measured in other terms such as:

Beta

Beta shows the relativity between the value of stocks and their relevant market index. It also represents the approximate volatility in returns of securities against that of its relevant benchmark index. Hence, it is a concrete representation of stock volatility. 

For instance, if a specific stock shows a beta value of 1.2 and its relevant benchmark index is Nifty 50, then it denotes that for a 100% change in the Nifty 50 index, that stock will move 120% in value. On the other hand, a beta value of 0.8 denotes that for a 100% change in the Nifty 50 index, its stock price will move by 80%. 

A higher beta value implies a high correlation with the index and therefore, high volatility, i.e. market dependency. 

Volatility Index (VIX)

Volatility Index is dependent on investor’s predictions regarding the movement of specific securities or the broader market. This index was developed by the Chicago Board Options Exchange and takes into account investor opinion. A high VIX indicates a volatile and risky market, whereas a low VIX indicates a low-risk market. 

Wrapping Up

What is Volatility Smile?

This is a graphical shape that emerges as a result of plotting the implied volatility and strike price of a bunch of contracts. Remember, these are contracts that have the same underlying asset and expiration date. When an underlying asset moves far from out-of-the-money to in-the-money or vice versa, its implied volatility first declines. It thereafter reaches a low at an at-the-money point and then rises. 

Due to this phenomenon, the shape seems like a smile! An options contract witnesses the lowest implied volatility when it is at the money; i.e. the underlying asset’s strike price and market value are similar. 

What is a Volatility Skew?

Unlike the balanced volatility smile, a volatility skew is more skewed. It depicts the different IV among an out-of-the-money option, in-the-money option, and an at-the-money option.

A graphical skew appears when one phenomenon is assigned higher implied volatility compared to another. 

A Quick Recap

1. Volatility is used in option pricing formulas to gauge the fluctuations in the returns of the underlying assets. 
2. A surge or dive of 1% in market indexes classifies it as a volatile market.
3. Historical volatility refers to the measurement of volatility over a sustained period based on historical movements in returns or prices.
4. Implied volatility helps determine the future of a particular stock’s value, without taking into account its historical data.
5. Volatility can also be measured by beta and volatility index.
6. Volatility Smile is a graphical shape that emerges as a result of plotting the implied volatility and strike price of a bunch of contracts.