How to Deal With Market Volatility in Your Favor
No matter what market you want to invest in, you will definitely meet with volatility. Volatility is an essential part of financial markets. The most common mistake of newbie investors is that they believe that volatility can appear and disappear.
The volatility always exists. The only difference that determines the success of your investment is the strength of volatility. Let’s clarify how to use the power of price volatility in your favor.
What Is Volatility?
In common words, volatility is a measure that determines the rate at which the price of the security changes for the set of returns. Volatility is used to determine the market fluctuation and understand whether the asset is risky or not. It is calculated by a standard deviation.
As we said above, volatility has different grades. It can be high, medium, and low. The higher the volatility is, the riskier the security is.
Volatility is used to determine the market fluctuation and understand whether the asset is risky or not.
There are well-known examples of markets and securities that relate to a specific volatility grade. For instance, the oil market is considered as a highly volatile one. The silver market is known as having low volatility. If we are talking about Forex, the Australian dollar and New Zealand dollar are generally known as highly volatile. However, the grade of volatility will also depend on the period you consider.
The stock market, in general, is a subject of high fluctuations. At the same time, the volatility grade may differ regarding the stock you trade. For example, Microsoft stocks have a medium rate of volatility as Microsoft is a blue-chip company. While shares of a new company that is barely known in the market will be highly volatile.
It’s crucial to understand that the same asset can be commonly considered as risky (being subject to high volatility). Still, its volatility will depend on the period you consider.
Types of Volatility
Although there is a general term for volatility, it’s essential to understand the difference in its types.
This type is also known as backward-looking. To calculate the historical volatility, you need to determine the asset's standard deviation from its average price for a particular period. You can use both intraday prices and close prices. The average period of intraday calculation varies from 10 to 180 days.
Historical volatility is backward-looking.
For example, if the price of a stock has an average volatility of 20% within the past period of 100 days and 30% within the last ten days, it means the volatility has increased.
When historical volatility rises, it’s more likely that the asset's volatility will deviate from the standard. Thus, it’s either something that will affect the market that has happened or will happen soon. At the same time, if the historical volatility declines, the market will return to the usual conditions.
Unlike historical volatility, implied volatility is forward-looking. The type is mostly used for options trading. To calculate the implied volatility, it’s not possible to take historical data. It’s essential to evaluate the potential of the option in the market.
To do that, traders gauge supply and demand. Seeing a significant deviation in them, the trader can expect changes in the price of the asset (mostly stocks) they plan to consider. Options premium serves as a barometer. It rises in price when there is a sharp deviation in either supply or demand, and falls when the value is near equilibrium.
Implied volatility can’t predict the direction of the security’s price but can predict where the volatility will be in the future.
Traders can combine historical and implied types to determine whether the security is overvalued or undervalued. If both types show the same values, then the security is supposed to be reasonably priced. After that, traders consider deviation from the equilibrium to define whether the security is undervalued or overvalued.
Besides two major volatility types, there is another one. It’s intraday volatility. The name clearly shows the core of this type.
Intraday volatility depicts asset fluctuations between open and close prices within one day.
To calculate volatility, you need to measure the range of the previous trading day. The range is measured by the difference between the highest and lowest prices. Afterward, traders decide what percentage will be comfortable for them to enter the trade. Mostly, they use 70%. A higher percentage is considered less risky to enter the market.
To make it easier, let’s look at an example. Let’s assume a day before an asset traded in the range of $6.5-$7.50. So, the range is $1, or 100 cents. If you want to enter the trade at 70%, wait until the price is 70 cents above the open price (buy position) or 70 cents below the price (sell position).
How to Calculate Volatility
There are two main methods to calculate the volatility. They are variance and standard deviation. However, they are interconnected. The standard deviation is measured as the square root of the variance. Look at the steps below:
- Let’s imagine you count volatility for the last 10 days. For that, you need to take close prices for those days. To make your calculation easier, it’s better to use Excel.
- The second step is to count the mean of these figures. You should add each figure, then divide the sum by the number of values.
- Let’s imagine; the close prices went from $10 to $100. So, on the first day, we had $10, on the second $20, etc. As a result, we have $550. After, we divide 550 by 10 you get $55.
- The third step is to find the deviation. All you need to do is to take each figure and subtract the mean from it. For example, $100-$55=$45, $90-$55=$35, etc. It’s more likely you will have negative means, which is acceptable.
- To remove the negative values, just square the deviations.
- Add squared deviations together. In our example, we have 825.
- The next step is to divide the previous sum by the number of figures (10). As a result, we have $82.5.
- And the final step to get the standard deviation is to calculate the square root from $82.5. As a result, our standard deviation is approximately $28.7. This number shows how far the price can deviate from the average mean.
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