Volatility
Volatility is a statistical measure of the dispersion of returns for a security or market index, indicating how much the price fluctuates over time—higher volatility means greater price swings and higher risk.
Exam Tip
Volatility = price fluctuation = risk. Beta measures relative volatility. VIX measures market fear. Higher volatility = higher option premiums.
What is Volatility?
Volatility measures how much and how quickly the price of a security changes. High volatility means large price swings (up or down), while low volatility means more stable, predictable prices. It's a key measure of investment risk.
Types of Volatility
| Type | Description | How Measured |
|---|---|---|
| Historical Volatility | Past price fluctuations | Standard deviation of returns |
| Implied Volatility | Expected future volatility | Derived from option prices |
| Realized Volatility | Actual volatility that occurred | Backward-looking calculation |
Measuring Volatility
Standard Deviation - Most common measure
- Higher standard deviation = more volatile
- 68% of returns fall within ±1 standard deviation
- 95% of returns fall within ±2 standard deviations
| Standard Deviation | Volatility Level |
|---|---|
| < 10% | Low volatility |
| 10-20% | Moderate volatility |
| 20-30% | High volatility |
| > 30% | Very high volatility |
Beta as Volatility Measure
| Beta | Meaning |
|---|---|
| Beta = 1.0 | Same volatility as market |
| Beta > 1.0 | More volatile than market |
| Beta < 1.0 | Less volatile than market |
| Beta < 0 | Moves opposite to market |
VIX - The "Fear Index"
The CBOE Volatility Index (VIX) measures expected S&P 500 volatility:
| VIX Level | Market Sentiment |
|---|---|
| < 12 | Low fear, complacency |
| 12-20 | Normal volatility |
| 20-30 | Elevated fear |
| > 30 | High fear, market stress |
Volatility and Investment Types
| Investment | Typical Volatility |
|---|---|
| Money Market | Very low |
| Government Bonds | Low |
| Corporate Bonds | Low to moderate |
| Large Cap Stocks | Moderate |
| Small Cap Stocks | High |
| Emerging Markets | Very high |
| Cryptocurrency | Extremely high |
Volatility and Options
Implied volatility affects option prices:
| Implied Volatility | Option Premium |
|---|---|
| High IV | Higher premiums |
| Low IV | Lower premiums |
This creates strategies:
- Sell options when IV is high
- Buy options when IV is low
Managing Volatility
| Strategy | How It Helps |
|---|---|
| Diversification | Reduces portfolio volatility |
| Asset Allocation | Mix high/low volatility assets |
| Dollar-Cost Averaging | Reduces timing risk |
| Hedging | Use options to limit downside |
Key Relationships
| Factor | Effect on Volatility |
|---|---|
| Market uncertainty | Increases volatility |
| Economic news | Can spike volatility |
| Low liquidity | Increases volatility |
| Longer time horizon | Smooths out volatility impact |
Study This Term In
Related Terms
Beta
SecuritiesBeta is a measure of a security's volatility relative to the overall market, where a beta of 1.0 means the security moves with the market, above 1.0 means more volatile, and below 1.0 means less volatile.
Systematic Risk (Market Risk)
SecuritiesSystematic risk is the inherent risk that affects the entire market or asset class, which cannot be eliminated through diversification and includes factors like interest rates, inflation, and recessions.