Volatility: An Introduction
If you are an investor in the markets, volatility is a concept you should know
If you have been following the news lately, you must have heard the term ‘volatility’. So, what exactly is volatility?
Volatility is synonymous with uncertainty.
Going into the technical definition, volatility is the standard deviation of annual returns over a time period. It is usually represented as a percentage.
Didn’t get that? It is basically the range over which an asset’s price is expected to fluctuate, but not the direction.
In periods of high market volatility, the market moves steeply up or down and the volatility index rises. Once the market becomes more ‘stable’ the volatility index goes down.
How is volatility measured?
The Chicago Board of Options Exchange (CBOE) was the first to introduce the volatility index and based it on the S&P 100 Index options.
Volatility in India is measured using the India Volatility Index (VIX) which is computed by the NSE based on the Nifty options order book. It calculates volatility for the next 30 calender days.
The following factors are taken into consideration when computing VIX.
- Time to Expiry
- Interest Rate
- The Forward Index level
- Bid-Ask Quotes
If you are interested in knowing more about how India VIX is calculated, here’s a white paper.
If the VIX rises, investors and traders are very uncertain about the market and the magnitude of movement is expected to be high. The VIX falls when participants are confident about future market movement.
Currently, the VIX (26 April) is at 21.71. This means that in the next month, market participants expect the Nifty to move by an annualized rate of 21.71% in either direction.
Historically, when the VIX is very high, the market tends to correct downwards.
What influences volatility?
A lot of factors affect market volatility. Be it a central bank’s decision to change interest rates, geopolitical issues, company mergers and acquisitions, natural disasters or major political events; all of them influence volatility.
Let’s take the current scenario in India. With the general election results due on May 23, uncertainty has risen over which party will take over the throne for the next 5 years. As a result, the NSE India Volatility Index (VIX) has risen to a multi-year high.
What is good — high or low volatility?
It depends. Lower volatility implies a relatively stable stock or market with fewer fluctuations. Low volatility entails lower risk, but also lower returns.
A person closer to retirement or a risk-averse investor would want to avoid investing in times of high volatility as it entails a large probability of loss and instead invests in relatively stable stocks or something like liquid funds.
Although risky, high volatility has a positive side too. They provide increased opportunities for an investor to earn significant returns. A risk-taking investor can cash in on the wide market fluctuations but faces the risk of a substantial loss as well.
Minance is a private wealth management firm. To know how we can help with your investments, click here.
To read more insights on finance, business, and economics, click here.
