Volatility is a word you hear quite often in news summaries about financial markets. And it means “volatility. But what is this volatility and how important is it for trading? Let us try to find out.
Sometimes the market sees great price swings, and sometimes it is completely calm. When you compare it to the sea, it explains very well the different market conditions. When the sea is calm, there are almost no waves, just ripples. But when the storm breaks, the waves can be several meters high.
The same is on the market – the stronger is the price jumps up and down, i.e., the higher is the range of price movements, the higher is its volatility. And vice versa, when the market calms down, the volatility goes down, as the price swing is reduced to a minimum.
Volatility is the spread, the deviation of the exchange goods price over a period of time (day, month, week, year) from the price level or the main market direction. Volatility is usually calculated as a percentage of the price of the asset.
Benefit or harm
On the one hand, high volatility gives you the opportunity to make more money in the market. With big price fluctuations, the difference in the purchase and sale price, on which you can make a profit, increases. But it is possible to earn more only if one can predict the direction of the market and the price movement of one’s asset. If not, the risks of losses increase sharply. And in this case, the volatility is only to the trader’s detriment.
Knowing and understanding the volatility is important to identify the minimum and maximum prices for an asset. If there is no important news, the asset will move within its average volatility. For example, if a stock’s price moves within ± 1% during the day, it is unlikely that it will start to move within ± 3% in the next few days. You need a good reason for that.
Volatility helps you make predictions and bets based on previous fluctuations in value. But it can also be very dangerous.
The example of Tesla is very telling. Watching the paper take off in recent months is a pleasure! From the beginning of 2020 to mid-February, Elon Musk’s stock soared 119%. And looking at how dashingly the paper is up $50 a day, you realize what a chance you missed by not buying it in time. But it’s not that simple. The run-up period was preceded by a period of volatility.
During the period of low volatility, the maximum price spread of Tesla stock was $23.53, ranging from $283.37 to $306.9. Volatility in this range is less than 8%. But after that period of calm, the price spiked from $291.13 to $370.80. And then came a period of greater volatility, when the spread in price averaged $118 – from $261.95 to $379.57. Volatility rose to 45%.
As investors became accustomed to the volatility, they opened short positions on price peaks. And those who wanted a profitable ride on the wave of volatility missed the direction of Tesla stock’s upcoming rise by nearly 150% and lost $8.4 billion, analyst firm S3 Partners estimated. For one day only on February 4, when Tesla shares renewed their historical maximum, the “shortists” lost $2.5 billion.
Why volatility changes in the market
The strongest market movements occur after periods of very low volatility. Market participants get “tired of being bored” during slack periods and happily enter the game as soon as the opportunity arises. It is in such moments when you can make the most money.
As a rule, the longer the period of “calm” on the market, the more likely it is that prices will rise or fall harder and faster. This is the law of the market. But unfortunately, it is impossible to predict exactly how long the “doldrums” will last and how long the subsequent move will be, and most importantly, in which direction.
More and more players are opening positions, and the price movement of the asset becomes sharper and stronger. The more so when large players enter the market by large volumes. And then emotions come into play. If the prices go up, the greed of traders grows – everyone wants to take a big piece of the pie. When the prices fall, fear grows. And the price starts to rise sharply and then fall just as sharply.
The increase in the range of price fluctuations suggests that panic is building up on the market. And the more big players panic, the greater is the amplitude of fluctuations. It is very dangerous to enter such a market when emotions are running high. It is emotions – fear and greed – that often rule the market more than fundamental news.
But such a bacchanalia can’t last long. Traders are exhausted – emotions subside, and the market calms down. The period of low volatility comes again – the calm but calm before the next storm. After a period of strong volatility, the market is always in the calm zone, which is sure to be followed by a period of high volatility.
How to use volatility in stock trading
Usually, periods of low market volatility give way to periods of high market volatility. To reduce the risk of losses, many traders prefer to enter the market during slack periods – and wait for increased activity and, therefore, the scope of price fluctuations. And this is the correct tactic.
- If volatility is low, it means that the order book on the exchange is balanced, that is, the price will not change, as long as the trading volume remains the same. If, however, there is a sudden increase in the number of sellers or buyers, the price can change dramatically.
- If the volatility is high, it is very dangerous to enter the market. It is necessary to understand that the train is already missed and wait for the next opportune moment to enter the market.
- If the volatility is falling. Low and declining volatility is characteristic of price growth. If the volatility continues to decrease, it may be a bullish sign.
- If volatility rises, it indicates increased nervousness in the market. The market offers good opportunities to open positions, but risks of losses become higher as well.