When selecting a security for investment, traders look at its historical volatility to help determine the relative risk of a potential trade. Numerous metrics measure volatility in differing contexts, and each trader has their favorites. A firm understanding of the concept of volatility and how it is determined is essential to successful investing.
The most simple definition of volatility is a reflection of the degree to which price moves. A stock with a price that fluctuates wildly—hits new highs and lows or moves erratically—is considered highly volatile. A stock that maintains a relatively stable price has low volatility. A highly volatile stock is inherently riskier, but that risk cuts both ways. When investing in a volatile security, the chance for success is increased as much as the risk of failure. For this reason, many traders with a high-risk tolerance look to multiple measures of volatility to help inform their trade strategies.
- Standard deviation is the most common way to measure market volatility, and traders can use Bollinger Bands to analyze standard deviation.
- Maximum drawdown is another way to measure stock price volatility, and it is used by speculators, asset allocators, and growth investors to limit their losses.
- Beta measures volatility relative to the stock market, and it can be used to evaluate the relative risks of stocks or determine the diversification benefits of other asset classes.
Calculating Volatility with Average True Range
The primary measure of volatility used by traders and analysts is the standard deviation. This metric reflects the average amount a stock's price has differed from the mean over a period of time. It is calculated by determining the mean price for the established period and then subtracting this figure from each price point. The differences are then squared, summed, and averaged to produce the variance.
Because the variance is the product of squares, it is no longer in the original unit of measure. Since price is measured in dollars, a metric that uses dollars squared is not very easy to interpret. Therefore, the standard deviation is calculated by taking the square root of the variance, which brings it back to the same unit of measure as the underlying data set.
Although other volatility metrics are discussed in this article, standard deviation is by far the most popular. When people say volatility, they usually mean standard deviation.
Chartists use a technical indicator called Bollinger Bands to analyze standard deviation over time. Bollinger Bands are comprised of three lines: the simple moving average (SMA) and two bands placed one standard deviation above and below the SMA. The SMA is a smoothed out version of the stock's price history, but it is slower to respond to changes. The outer bands mirror those changes to reflect the corresponding adjustment to the standard deviation. The standard deviation is shown by the width of the Bollinger Bands. The wider the Bollinger Bands, the more volatile a stock's price within the given period. A stock with low volatility has very narrow Bollinger Bands that sit close to the SMA.
In the example above, a chart of Snap Inc. (SNAP) with Bollinger Bands enabled is shown. For the most part, the stock traded within the tops and bottoms of the bands over a six-month range. The price was between about $12 and $18 per share.
Another way of dealing with volatility is to find the maximum drawdown. The maximum drawdown is usually given by the largest historical loss for an asset, measured from peak to trough, during a specific time period. In other situations, it is possible to use options to make sure that an investment will not lose more than a certain amount. Some investors choose asset allocations with the highest historical return for a given maximum drawdown.
The value of using maximum drawdown comes from the fact that not all volatility is bad for investors. Large gains are highly desirable, but they also increase the standard deviation of an investment. Crucially, there are ways to pursue large gains while trying to minimize drawdowns.
Many successful growth investors, such as William J. O'Neil, look for stocks that go up more than the market in an uptrend but stay steady during a downtrend. The idea is that these stocks remain stable because people hold on to winners, despite minor setbacks. That reveals potential winners and lets the growth investor buy a stock where the volatility is mostly on the positive side, at least initially. As time passes, the stock will eventually experience larger losses during downtrends. Speculators see this as a sign to look for a new winning stock or go to cash before a bear market begins.
A stop-loss order is another tool commonly employed to limit the maximum drawdown. In this case, the stock or other investment is automatically sold when the price falls to a preset level. However, gaps can occur when the price moves too quickly. Price gaps may prevent a stop-loss order from working in a timely way, and the sale price might be below the preset stop-loss price.
Beta measures a security's volatility relative to that of the broader market. A beta of 1 means the security has volatility that mirrors the degree and direction of the market as a whole. If the S&P 500 takes a sharp dip, the stock in question is likely to follow suit and fall by a similar amount.
Relatively stable securities, such as utilities, have beta values of less than 1, reflecting their lower volatility. Stocks in rapidly changing fields, especially in the technology sector, have beta values of more than 1. A beta of 0 indicates that the underlying security has no market-related volatility. Cash is an excellent example if no inflation is assumed. However, there are low or even negative beta assets that have substantial volatility that is uncorrelated with the stock market. Gold and long-term government bonds are the best examples of such assets.