Market Volatility Explained

What is Volatility?

According to the Investopedia definition: “Volatility is a statistical measure of the dispersion of returns for a given security or market index.” In more simple terms, when you are looking at a financial chart and you see the price moving up and down over time? That is called “volatility.”

Market volatility is essentially a measurement of price fluctuation. Take the FX market for example. A currency with dramatic upswings and downswings (the price increase and decrease) is said to have volatility. Simply put, the more a price moves the more volatile the asset is and vice versa. Traders use volatility as one of the deciding factors when buying and selling securities.

Volatility goes hand in hand with risk – and therefore potential profit. As a general rule of thumb, the higher the volatility, the greater the risk and resulting overall gain available. A market is described as “volatile” when it is experiencing particularly stark or frequent price up and downswings. Take the wild peaks and troughs of the digital currency market, one of the best examples of “volatility” in finance.

 

How Do You Measure Volatility?

There are a few ways you can work out price volatility. The method changes depending on the market in question. Let’s take FX for a start.

1. Moving Averages (SMA)
2. Average True Range (ATR)
3. Bollinger Bands

 

01. Moving Averages:

The most popular way for FX traders to calculate volatility is with moving averages. This simple indicator is an invaluable trading tool, a virtuoso skeleton key for technical trading across financial markets. The average movement of the market is assessed over a certain time frame (10 SMA would be the moving average over the last ten days).

 

02. Average True Range:

Also known as the “ATR,” the Average True Range is calculated by using the range of the currency pair in question which is plotted as a moving average. ATR is an excellent tool for measuring volatility because it reflects the average trading range of the market over a set time period.

 

03. Bollinger Band:

Two lines plotted above and below the SMA (over a set timeframe). A contracting Bollinger band indicates LOW volatility, while an expanding Bollinger band shows HIGH volatility.

 

Volatility can be stated in different time frames depending on the specific period (daily, weekly, monthly or annual volatility). When assessing stocks, one way to check market volatility is by looking up the Volatility Index (VIX).

The VIX was created by Professor Robert Whaley in 1993 as a way to gauge the 30-day volatility of the U.S. Stock Market. Originally for the Chicago Board Options Exchange, the VIX is now the standardized measure for predicted U.S stock volatility. The VIX is a barometer of the bets investors are making on price action. The higher the VIX, the riskier the market.

 

Volatility Through the Years

The easiest way to understand the concept of volatility is to look at some of the real market examples. The financial annals of history are marked by some legendary periods of volatility – explained by the contextual past and which impacted the financial future thereafter. Understanding periodic volatility is important as past events can be used as a marker (while not a mirror) for future price action.

 

Wall Street Crash 1929

Do you remember the Great Depression? Probably not – it began in 1929 and saw the stock market lose over 90% of its value before 1933. Over ten thousand banks failed, wiping out the savings of millions of Americans. The unemployment rate grew from 3% in 1929 to a staggering 25% just four years later. Why? The worst economic recession in the industrialized world was triggered by what became known as the Wall Street Crash and “Black Tuesday.” The causes are manifold, but in essence, the Great Depression was set off by the 1920s “boom” of speculation which pushed prices unrealistically high. On Black Tuesday, the Dow Jones fell by 12% (one of the biggest drops in history) causing panic and a mass selloff.

 

1987 Stock Market Crash

Also known as “Black Monday,” the 1987 crash in the U.S. Stock Market was believed to be tech-triggered due to “program trading.” In reality, there was a period of excessive speculation in the period leading up to the crash which caused an enormous volatility spike. When the stock market crashed on Monday, October 19 the Dow Jones fell by 22% and sent a domino effect through global stocks. There was a 130% spike in volatility following the eventful Monday. Today, there are measures in place (circuit breakers and trading curbs) to prevent massive selloffs.

 

2008 Crash

While you may not recall the Great Depression, you likely do remember the 2008 financial crisis. This time around, the economic downturn was caused by years of lax lending and cheap credit which enabled a housing bubble. The financial institutions involved were left with trillions of near valueless subprime mortgage investments when the bubble burst.

Of course, since then there have been countless geopolitical events of note which have impacted the global financial markets (Brexit, COVID, etc.). Each incident is an example of the power of volatility in trading. No matter your trading time frame or style, traders must understand the importance of this market indicator.

 

Implied versus historical volatility

There are two main types of volatility: implied and historical. There are nuanced differences between them which we will briefly gloss over here.

1. Implied Volatility (IV): IV or “projected volatility” is the go-to metric of options traders. In a nutshell, traders use IV to get an assessment of the market’s future volatility and therefore decide whether or not to make certain trades. Like all calculations of impending price direction, projected volatility is a probability – not a guaranteed outcome. IV is “implied” on the basis of the asset’s price (not past performance).
2. Historical Volatility (HV): Also known as statistical volatility, HV calibrates the changes in price of a security over a predefined time frame. An increase in HV denotes an impending change in price action while a dip suggests a return to routine activity after a period of variation.

 

Takeaway

Market volatility is neither friend nor foe – it is a trading tool. By learning to identify the markers traders can begin to spot volatile periods and time their positions accordingly. Look at the digital currency market after all – if you trade a volatile market right you walk away winning.

With ForexBros you trade with the best in the biz! Sign up today and make the most from market volatility across over 12 assets.