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Describing Volatility
Volatility measures how quickly a security’s price will fluctuate over time.
A market or asset is said to be experiencing volatility when periods of unexpected, occasionally abrupt price changes occur.
Volatility is frequently associated with price declines, although it may also apply to sharp price increases.
So how is volatility determined?
Volatility tracks changes in price over a predetermined time frame.
Volatility, the pace at which a security’s price grows or declines, is defined statistically as the standard deviation of a market or asset’s annualized returns over a particular period.
High volatility is a price’s quick and significant swings between new highs and lows. Conversely, low volatility is defined as slower up- or down-moving or more steady price movements.
Whereas implied volatility examines anticipated future volatility using the market price of a market-traded derivative like an option, historical volatility is determined using a series of previous market prices.
What creates volatility?
Volatility may result from a variety of factors, including:
- economic and political considerations
As governments decide on trade agreements, laws, and policies, they play a significant role in regulating sectors and have the power to influence an economy. In addition, investors’ emotions affect share prices, which can be sparked by anything from speeches to elections.
Economic data is necessary because investors often respond favorably when the economy performs well. Market performance can be affected by monthly job reports, inflation statistics, consumer spending data, and quarterly GDP projections. In contrast, markets could become more erratic if these fall short of market expectations.
- Sector and industry factors
Certain occurrences within a sector or business can bring on volatility. For instance, a significant weather occurrence in a critical region for oil production might increase oil prices. Consequently, firms involved in oil distribution may see an increase in share value since they stand to gain, while companies with high oil expenses may see a decline in value.
Similar to the previous example, more government regulation in a particular industry may cause stock values to decline owing to higher compliance and labor expenses that may influence future profit growth.
- Enterprise performance
Volatility might affect a single firm rather than the entire market.
Good news can boost investors’ confidence in the company, such as a solid earnings report or a new product that delights customers. However, if numerous people try to purchase it, the greater demand may contribute to a rapid spike in the share price.
On the other hand, a share price might be negatively impacted by a product recall, data breach, or inappropriate management behavior when investors sell off their shares. This sound or bad performance may also affect the larger market, depending on the firm’s size.
FINAL INSIGHT
Risk and volatility are interchangeable based on the definitions provided here. Yet, they aren’t.
Risk is just a forecast of loss and, by extension, a permanent loss, whereas volatility predicts future price movement, including failures and profits.
Of course, they are connected. Moreover, volatility is crucial when figuring out how to reduce risk. Yet, combining the two might significantly reduce your portfolio’s earning potential.
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