You may be wondering what causes stock market volatility? Stock prices can go up, down or “sideways” (stay about the same over time).
Typically, long-term investors buy stocks in the hopes that prices of the stocks they own will increase as companies grow and enhance their profits.
Short-term “traders,” or “swing traders,” who are more interested in a stock price movement reaching their goals in only few days or weeks, can make money if a stock goes up, or they can profit by “selling short” shares of a stock, benefiting if a stock price drops.
Regardless of whether a trader is positioned to be successful if a stock price goes up or down, nothing happens unless a stock’s price moves in one direction or the other. In these cases, the stock should have some degree of “volatility.”
Stock Market Volatility Defined
As you might suspect, the term “volatility” is defined in Merriam-Wester’s dictionary as “a tendency to change quickly and upredictably.”
Regarding the stock market, a stock’s volatility is the expected movement of a stock’s price during a certain period of time, generally referred to as “implied volatility” or “IV.”
Implied volatility reflects the expectation of the “crowd” (the marketplace sentiment) as to the degree of price movement. A high volatility value indicates a high level of uncertainty by the crowd.
You might be inclined to think of implied volatility as a “forward-looking” metric, which can be used as part of a trader’s analysis to determine the next potential price swing of a stock.
How To Measure Stock Market Volatility
The volatility of a stock is based in part on the mathematical concept of “standard deviation”. You might remember the “bell shaped curve” from high school math class.
This plotted graph resembles the silhouette of a bell, having a camel-like hump in the middle, which thins and flanges out at the left and right side bottom sides.
A standard deviation plot shows how data, numbers or items are distributed. Simply put, statistics state that about 68% of the data or items will lie within the area under the curve marked by one “standard deviation.”
About 95% will fall within two standard deviations. Obviously, at two standard deviations, the odds are extremely high. Finally, about 99% will plot within three standard deviations.
The bell curve shows a normal distribution that occurs naturally most often, and is symmetrical.
Half of the data will fall to the right of the center, or “mean” line, and the other half will fall to the left. So, standard deviation measures the distribution of a data set relative to its mean.
In the field of education, SAT, GRE and other test scores follow the standard deviation pattern. In medicine, where your blood pressure number falls on a bell curve will tell your physician if your pressure falls within the area considered “normal.”
Standard deviation plays an important role in financial markets, especially in trading options.
This is because standard deviation shows “expected move,” that is, a price range in which a stock’s price is likely to trade during a specific period of time. The standard deviation determines the width of the bell curve.
Regarding options, implied volatility is a representation of one standard deviation move over a set period of time. Implied volatility. So, a stock’s options volatility is used in predicting the expected move of the stock.
Take a bell shaped curve and draw a line down the center, from top to bottom. Draw a line from the top to the bottom a little ways to the left of the center line, and a line to the right.
These lines define the area of one standard deviation. Of course, where these lines are actually plotted will depend on volatility.
This area represents the area in which there is the probability of a stock’s price falling in this area about 68% of the time.
To clarify, let’s say a stock price is at $100, and the stock has an implied volatility of 20%. 20% of $100 is $20, so in theory, the stock can be expected to move between $80 and $120 about 68% of the time.
Knowing the range a stock is likely to move in the short term is especially valuable for options traders who are using spread strategies.
This does not tell us if a stock is expected to go up or down, just that it is likely to trade in a given range.
Options traders can use spread strategies, short iron condors and straddles, to make a profit if a stock stays in a predicted range during the life of the option position.
A stock’s volatility is given a value called “beta”. Use any free online charting website (such as finance.yahoo.com/quote) that shows a company’s fundamentals, and look for beta.
This number is a comparison of a stock’s volatility to the overall volatility of the market. A beta greater than 1 indicates a stock is more volatile than the overall market.
Stocks with a beta greater than 1 will most likely go up more than the overall market goes up, and will likely go down more than the market goes down.
Similarly, a beta less than 1 typically will not move as much with movements in the overall market.
Rather than using a stock’s beta, options traders use implied volatility to measure the market’s expectations for the underlying stock’s performance during the lifetime of a specific option’s contract.
This value looks at the range of where implied volatility has been over the last year, and gives an indication of how the stock’s price range is currently trading in respect to itself.
This gives a better indication as to how big an expected move is relative to the last year. A high IV Rank means option prices are inflated relative to the last year.
Putting implied volatility in context to create Implied Volatility Rank is extremely valuable to options traders, guiding them as to the type of trading strategy to employ.
To get a measure of the volatility of the overall market, the Chicago Board Options Exchange created a metric called the “VIX.”
A normal value for the VIX is about 15 to 20. Since this reveals the sentiment of the crowd, the VIX is referred to as the “fear index,” because a high value indicates uncertainty in the market.
The “SPY” is a fund comprised of many stocks that give a representation of how the market is moving in general. You can trade the SPY just like any stock.
When the SPY moves down, the stock prices of many major companies is falling. The crowd is getting worried! Fear is increasing.
As you might expect, when the VIX goes up, the SPY is going down in price. When the VIX is going down, the SPY is rising, and traders in general are less fearful of sudden price movements.
How Is Volatility Profitable In The Stock Market?
As mentioned earlier, traders can plan strategies based on the volatility of a stock. This is especially true for options traders. Unlike trading stocks, option traders have many strategies available to them.
They can structure positions that will benefit if a stock goes up, goes down, moves sideways, or even if it moves up or down (as long as it is in a determined range).
Knowing the volatility of the underlying stock is key to option traders selecting the type of strategy to use and other parameters needed to set up that particular trade.
Novice traders often use less risky strategies, such as vertical spreads and iron condors.
Advanced traders use riskier, but more profitable, strategies, such as calender spreads, butterflies, diagonal spreads, straddles, strangles and other combinations of calls and puts.
When it comes tor trading options, both high and low risk strategies depend on traders knowing a stock’s volatility.
Option traders typically focus on selling option contracts to collect premiums when volatility is high. Conversely, they’ll buy options in low volatility environments.
Historical Volatility, or “HV,” is a backward-looking metric. It gives a measure of how a stock has moved in the past over a set period of time, typically the past year.
Option traders sometimes attempt to determine if an option’s current price is fair by comparing it to historical volatility.
This, however, is not always an accurate predictor of future volatility, but it is one more tool in a trader’s tool box of technical indicators.
What Is Behind Market Volatility And Why Is It Currently So High?
As of this writing in March of 2022, there are many forces at work creating significant volatility in the market. There is geopolitical news regarding the Russian invasion of the Ukraine.
The Covid pandemic is changing as the world moves to learn how to live with continued remnants of the virus ever present.
Finally, after enjoying many years of low interest rates and low inflation. Inflation is the highest it has been in as long as many people can remember.
In an attempt slow and reduce inflation, the Federal Reserve System, the central banking system of the United States, is planning to raise it’s interest rates.
These are all major factors that are affecting current market volatility.
This is in addition to the usual reasons that affect a stock’s volatility, which include when a stock pays a dividend, when a company releases an earning announcement (which is usually done quarterly), the launching of a new product and any “shock” event such as a change of leadership or merging with another company.
How To Handle Stock Market Volatility
Stock traders may experience trouble handling volatility, as they can only buy, sell or short shares of a stock.
Their best bet is to use technical indicators, look for support and resistance levels, and use those for short term trading, buying shares at support then selling at resistance.
Options traders have much more flexibility, and can actually use volatility to their advantage.
Strategies such as vertical credit spreads can benefit by the higher premiums they collect in high volatility conditions.
Options also give traders “leverage,” that is, they can use a small amount of capital to take on positions where buying shares of a stock would be prohibitively expensive.
In Conclusion: What Causes Stock Market Volatility?
Long-term investors typically only make money if a stock goes up in price. They may also make money by capturing dividends.
Short-term traders can use the volatile movement of stock prices to buy and sell often, taking advantage of price movements.
Options trading, though more complex, can use volatility to their advantage in many ways.