Volatility refers to the upward and downward movement of price. The more prices fluctuate, the more volatile the stock market is, and vice versa. A higher level of volatility means that prices can change dramatically over a short time period in either direction.
For a market participant to benefit from a trading environment that is volatile and changing fast, the investor must either be willing to navigate all the twists and turns, or step back a bit and play the long game.
But how volatile is the stock market, really?
- A volatile stock market is one in which there is a fair amount of liquidity and price valuation.
- Not all markets are volatile, or not all markets are volatile at all times. There are variations in volatility that are seasonal, news, or event-specific, or even based on broader trends like election years and the general direction of fiscal policy.
- Volatility is often indicative of day-to-day market trading, but longer-term, the markets tend to move in one direction or another for a year or more.
- Volatility is not a negative concept if you have cash ready to make smart investing decisions during market downturns.
- Investors seeking to navigate the market benefit from either being in the thick of it, such as a day trader, or standing back and investing for the long term, such as someone planning for retirement or another big goal.
Volatility is a measure of the dispersion of returns for a given security or market index. Stocks or other securities with higher volatility are generally regarded as riskier than those that do not experience the same price oscillations. Stocks that experience large price swings are volatile. The market can experience the same "whipsaw" action during tumultuous periods, such as during a war or during the extremely volatile period from 2007 to 2009.
The longer the period of investing, the less that volatility will have an effect on the overall, long-term performance of a portfolio. Many risk-averse investors fear volatility and while it's true that a volatile market is psychologically hard to weather, long-term investing is not as affected as one might believe.
Is the Stock Market Really Volatile?
Yes, the stock market is sometimes volatile, but the degree of its volatility adjusts over time. Over the short term, stock prices tend not to climb in nice straight lines. A chart of day-to-day stock prices looks like a mountain range with plenty of peaks and valleys, formed by the daily highs and lows. However, over a period of months and years, the mountain range flattens into more of a gradual slope.
This implies that if you are planning to hold a stock for the long term (more than a few years), the market instantly becomes less volatile for you than for someone who is trading stocks on a daily basis.
For example, in August 2020, the S&P 500's five-year return was just more than 50%, the Dow Jones Industrial Average's return was around 50%, and the Nasdaq Composite surged over 110%.
Investors looking at the broader market versus specific securities will usually consult the CBOE Volatility Index, commonly referred to as the VIX. When the VIX is trending upwards, that means the market is experiencing a period of heightened volatility. In such cases, investors may choose to engage with the market less, as price movements become less predictable. Other styles of traders, such as day traders, love volatility, as it offers them more opportunities for short trading plays.
The stock market's volatility and VIX rating are determined by an almost infinite amount of considerations. Major events will always ripple through the market, such as interest rate hikes or commodity wars, commonly seen with oil. These events can trigger a bear market where increased volatility becomes the exception, not the rule. That being said, bear markets can present excellent buying opportunities for many different investment strategies.
How Volatility Affects Short- and Long-Term Investors
In some cases, short-term volatility is seen as a good thing, especially for active traders. The reason for this is that active traders look to profit from short-term movements in the market and individual securities—the greater the movement or volatility, the greater the potential for quick gains. Of course, there is the real possibility of quick losses, but active traders are willing to take on this risk to make quick gains.
Emotions can be high during periods of market volatility which is why it's extremely important to have a trading strategy based on empirical data, not a feeling or desire.
A long-term investor, on the other hand, doesn't have to worry about this day-to-day volatility of the market. As long as the market continues to climb over time, as it has historically, your good investments will appreciate and you'll have nothing to worry about. Because of this long-term appreciation, many choose to invest in the stock market.
How to Take Advantage of Volatility
Trading in volatile markets can be extremely profitable regardless of the time horizon. Those looking for long-term success in the market need to embrace volatility as a period of change and often a much-needed breather in a market that may have experienced significant recent gains. Arguably, there are two things investors must do before approaching investing in volatile markets, and that is to become comfortable with the volatility and have a risk-adjusted plan in place.
A common strategy is to observe indicators during volatile periods while looking for attractive entry points. Common indicators, other than the VIX, that are used are the relative strength index (RSI) the moving average convergence divergence (MACD) indicator, and the moving average (MA).
Traders and investors will watch these indicators and will open a position when they believe the security has been oversold, when it hits a predetermined price target, or when the trend changes and the investor confirms the entry point.
During volatile periods, many investors will increase the percentage of their portfolio that is dry powder. Having "dry powder" means having enough cash on hand that when an opportunity presents itself, the investor isn't sidelined from the trade due to a lack of liquidity or available funds in their portfolio. Although the broker may allow you to place the trade with margin, otherwise known as a loan, using the brokerage's money is extremely risky and can result in heavy debts being owed, and is generally avoided.
Is a Volatile Market Good for Profits?
What Is the VIX?
The CBOE Volatility Index, or the VIX, is a measure of the short-term volatility of the Chicago Board Options Exchange (CBOE). Investors watch the VIX closely as it is a good indicator of the overall volatility in the markets.
Does Diversification Help Reduce Volatility?
Diversification will usually help with volatility if the portfolio is diversified over many different market segments. A portfolio may be considered diversified if it owns stocks in many different companies but if all those companies operate in the same sector, and that sector plummets, the portfolio will experience exceptional volatility and won't really be protected. That is why many asset managers recommend broad diversification over many different securities and sectors so that even if an entire sector falls, the portfolio itself will absorb some of the volatility.
Is Bitcoin Volatile?
Bitcoin, at least at the of writing this article, is an extremely volatile instrument. Cryptocurrency as a whole is a relatively new concept and since it isn't pegged to a fiat currency, its value of it is speculative. Although many have made a significant profit from the coin, it is still considered highly volatile and should be invested in with extreme caution.
The Bottom Line
Markets need to be volatile sometimes in order to reset and breathe. Investors who know this and are both mentally and financially ready can take advantage of price swings. In fact, many investors prefer volatile markets, as there are more points of entry for both long and short-term investments.