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Views: One of the important indicators in financial markets is volatility, depending on it, market participants make their trading or investment decisions. It is important to realize that volatility itself is not good or bad, it only reflects the dynamics of price changes.
Volatility - what it is and what types of volatility there are
Volatility is a financial indicator that denotes the degree of price fluctuations for assets, such as cryptocurrencies, stocks, currencies, commodities and other investment instruments, in a certain period of time. The higher the volatility index, the more extreme the price changes.
Volatility can be short-term or long-term, and there are several types of volatility:
Historical volatility is a measurement of volatility over a past period of time. It shows how much asset prices have changed in the past.
Expected (or implied) volatility is projected volatility for the future based on current price data and market expectations. It is often used to assess future risks.
Return volatility - measures price changes based on percentage changes in asset prices. It helps traders analyze risk when trading stocks or other assets.
How volatility can be calculated
Volatility can be calculated using several methods, but the most common way is to use the standard deviation of returns. To do this, you need to:
Calculate the returns for each period.
Calculate the average return.
Calculate the deviations of each return from the mean.
Find the mean square deviation (standard deviation).
Example:
Suppose we have data on the price of a cryptocurrency for five days:
Day 1: $100
Day 2: $102
Day 3: $101
Day 4: $104
Day 5: $105
Calculate the return on each day:
Day 2: (102 - 100) / 100 = 0.02 (2%)
Day 3: (101 - 102) / 102 = -0.0098 (-0.98%)
Day 4: (104 - 101) / 101 = 0.0297 (2.97%)
Day 5: (105 - 104) / 104 = 0.0096 (0.96%)
Average return: (2% + (-0.98%) + 2.97% + 0.96%) / 4 = 1.2375%
Standard deviation (volatility) is the average deviation of returns from their average value.
Factors affecting volatility
Volatility is affected by various factors such as:
1. Economic factors
The economic performance of a country or region plays an important role in shaping volatility. Some of the major factors include:
1.1 GDP (Gross Domestic Product) trends
If the economy is growing, markets usually stabilize and volatility decreases. However, during economic crises or a slowdown in GDP growth, investors become more cautious, resulting in higher volatility.
1.2 Inflation rate
High inflation reduces purchasing power and causes uncertainty in the markets, leading to sharp price fluctuations. During periods of low inflation, markets tend to be more stable.
1.3 Changes in interest rates
Central banks, such as the US Federal Reserve or the ECB, regulate interest rates, affecting the cost of credit and the yields on financial instruments. Rising rates make equity investments less attractive, causing sell-offs and increased volatility. Lower rates, on the other hand, encourage investment by reducing price volatility.
1.4 Government policy and regulation
The introduction of new taxes, anti-trust measures, sanctions or other economic reforms can suddenly change market behavior, causing an increase in volatility.
2. Political events
Political stability or instability has a direct impact on markets.
2.1 Elections and changes of power
During elections, markets often exhibit increased volatility as investors are uncertain about the future economic policies of the new government. For example, US presidential elections can significantly affect stock indices.
2.2 Geopolitical conflicts and sanctions
Military actions, trade wars or sanctions restrictions create uncertainty that affects currency exchange rates, commodity prices and stock prices.
2.3 Political crises
Scandals, corruption investigations or protests can shake investor confidence, increasing fluctuations in markets.
3. Market factors
Some factors arise directly within the financial markets.
3.1 Speculative activity
High-frequency trading and active speculative trades can increase short-term volatility, especially during periods of uncertainty.
3.2 Market liquidity
When there are many buyers and sellers in the market, assets trade steadily and volatility is lower. However, when liquidity is reduced, even small transactions can cause sharp price spikes.
3.3 Market Manipulation
Sometimes large players can deliberately create sudden price changes (e.g., through massive buying or selling), leading to short-term spikes in volatility.
4. Psychological factors
The market depends a lot on the emotions and behavior of investors.
4.1 Panic and excitement
If investors start selling assets en masse due to fear of losses, it leads to increased volatility. The opposite situation is excessive optimism, when investors start actively buying assets, creating a “bubble”.
4.2 Crowd Effect
Many investors make decisions following the majority, which leads to rapid and chaotic market movements.
4.3 Expectations and forecasts
Analysts' assumptions and forecasts can influence the market in advance. For example, if a company's quarterly earnings are expected to be strong, the stock may rise sharply in value even before it is released.
5. Macroeconomic and global events
Major external events can dramatically affect the volatility of global markets.
5.1 Natural disasters
Earthquakes, hurricanes, tsunamis and other natural disasters can destroy infrastructure and economies, causing dramatic changes in stock markets.
5.2 Pandemics and epidemics
Example: the COVID-19 pandemic, which caused record volatility in stock markets in 2020 and caused oil prices to plummet.
5.3 Crises and recessions
Financial crises, such as the 2008 crisis, significantly increase volatility amid massive bankruptcies and falling markets.
6. Corporate factors
Volatility can be related to the situation within individual companies and industries.
6.1 Financial reports and company performance
Published earnings statements can cause significant changes in stock prices. If a company has exceeded analysts' forecasts, the stock may rise sharply and vice versa.
6.2 News about mergers and acquisitions
When merger deals are announced, the volatility of the stock can increase sharply due to investor expectations.
6.3 Scandals and Litigation
Scandals such as accounting frauds can dramatically crash a company's stock and increase market volatility.
Indicators used to assess volatility
Several popular indicators are used to analyze volatility:
The Volatility Index (VIX) is an indicator that is calculated based on S&P 500 stock option prices and shows the market's expectation of volatility over the next 30 days. The higher the index, the more volatile the market is considered to be.
Standard Deviation - helps measure the standard deviation of an asset's price from its average value over a certain period.
Bollinger Bands - This indicator uses standard deviation to create two bands that show the range in which an asset can fluctuate.
Average True Range (ATR) - calculates a measure of volatility based on the difference between the maximum and minimum price for the day.
Stock and Currency Volatility
Stock and currency volatility significantly affects the behavior of investors and traders. Stocks, especially those companies that are subject to high economic risks, can exhibit high volatility. Currency pairs, such as dollar/euro or pound/dollar, can also fluctuate widely, especially in response to economic or political events.
For traders, volatility is an opportunity for profit, as high price fluctuations can open up the potential to enter and exit trades with large profits.
How you can make money on volatility
There are several ways to make money from volatility:
Volatility-based trading - traders use short-term price changes to buy at low prices and sell at high prices.
Options and futures - using derivatives allows you to capitalize on changes in asset prices.
Hedging strategies - for more experienced investors, hedging strategies help reduce the risks associated with high volatility.
Trading on news - sharp price changes can occur on the backdrop of important news, and experienced traders can use this moment to capitalize on it.
Pros and Cons of Volatility for Investing
The pros of volatility for investors are:
1. Opportunity to make high profits
The higher the volatility, the greater the price fluctuations, which means that investors and traders have opportunities to make money. If you predict the market movement correctly, you can make significant profits in a short period of time.
Example:
Let's say a company's cryptocurrency was worth $100, but due to positive news it grew to $120 in just a week. A trader who bought the asset before the growth was able to earn 20% profit in just a few days.
2. Favorable conditions for active traders
Volatility opens opportunities for day traders, scalpers and news traders. They capitalize on rapid price changes by buying and selling assets within a short period of time.
Example:
A trader might buy a stock in the morning at $50 and sell it in the afternoon at $55, capitalizing on the day's fluctuations.
3. Opportunity to buy assets at a favorable price
During strong market fluctuations, asset prices can briefly decline. This creates a great opportunity for long-term investors to buy promising stocks or other assets at a discount.
Example:
During the 2020 recession, stocks of large technology companies like Apple and Microsoft plummeted in value. Investors who bought them at that point were able to realize multiple profits a few months later when the market recovered.
4. Increased liquidity
Volatile markets attract more participants by increasing liquidity - that is, the speed at which an asset can be bought or sold at the market price. This is especially important for traders working with large sums of money.
Example:
In a market with high liquidity, an investor can buy or sell stocks quickly without incurring significant losses on the difference between the buy and sell prices (spread).
5. Portfolio diversification
Volatility can contribute to better asset allocation. Investors can include both volatile instruments in a portfolio for quick profits and stable assets for capital protection.
Example:
An investor can hold some capital in safe bonds and some in volatile stocks or cryptocurrencies, creating a balanced portfolio.
The minuses of volatility for investors:
1. High risks of losses
The higher the volatility, the greater the likelihood of significant losses. If the market moves the wrong way, investors can lose capital quickly.
Example:
Tesla stock was worth $250, but after negative news about production problems, it fell to $200 in just a couple days. An investor who bought the stock at $250 would suffer a loss if he or she did not sell in time.
2. Emotional stress and psychological pressure
Sharp price fluctuations can cause fear and panic in investors, causing them to make rash decisions - selling assets on a dip or buying on a peak.
Example:
During the 2008 crisis, many investors panicked and sold assets at the low, locking in losses, and then watched as the market recovered and rose several times.
3. Difficulty in forecasting
High volatility makes technical analysis and forecasting more difficult because the market can behave erratically. Even experienced analysts are often wrong in their forecasts.
Example:
If the bitcoin rate rises sharply by 15% in a day, it does not guarantee further gains - it may fall by 20% the next day.
4. Increased trading costs
Frequent trading in conditions of high volatility leads to increased commissions and spreads. This is especially true for those who use margin trading and leverage.
Example:
A trader who makes dozens of trades per day can lose a significant portion of profit on broker commissions.
5. Possibility of market manipulation
In volatile markets, large players (institutional investors, market makers) can artificially influence prices by creating false trends and confusing retail traders.
Example:
In 2021, “pump & dump” schemes occurred in the cryptocurrency market, where large players inflated the price of an asset and then sold en masse, crashing the market.
Conclusion
Volatility is an integral part of financial markets, it can both create opportunities for making money and increase risks for investors. Knowing the factors affecting volatility, as well as using indicators and calculations, allows you to better navigate the markets and make informed decisions.
Frequently asked questions
1. What does high volatility mean?
High volatility means that asset prices change significantly in a short period of time, which can create both opportunities for gains and losses.
2. How can the risks associated with volatility be mitigated?
To reduce risks, it is important to diversify your portfolio, utilize hedging strategies, and keep up with economic and political news.
3. What is the VIX volatility index?
The VIX index measures the expected volatility in the S&P 500 market over the next 30 days and is often used as a gauge of market fears.
4. Can I make money on volatility if I have no experience in trading?
You can, but it is important to first learn the basic principles of trading and the risks associated with volatility to avoid large losses.
5. What is the role of volatility in the cryptocurrency market?
Volatility in cryptocurrency markets can create opportunities for traders to capitalize on changes in coin prices, but it also increases the risks of loss.
