If you’ve been listening to what passes for information from the financial press lately, you’ve been hearing the word “volatility” bandied about a lot.  You’ll here phrases like “volatility has increased” and “there’s more volatility in the market” filling the air — put there by scores of financial pundits who seem to be “in the know” about such things.

But if you’re new to investing — or just unfamiliar with some of the market jargon frequently spouted by the financial media — you may think that’s something you ought to know about.  Well, should you?  And more importantly, will becoming familiar with the concept of volatility help you improve your investment results?

The answer to those questions depends, to some degree, on what type of trader or investor you are.  If you trade actively, it certainly is important to know how volatility is affecting the market and what it means to your approach to trading.  And if you’re an options trader, an understanding of volatility is critical.  More on that later…

But what if you’re an investor?  Believe it or not, an understanding of volatility can assist you with your investment decisions.  By matching the amount of volatility you’re willing to accept as part of your investing program with your risk parameters and financial goals, you can tailor an investment portfolio that suits your temperament and comfort level.

How so?  Before I get ahead of myself, let’s define what “volatility” actually is.  Once we’ve defined the term, we can begin to look at a couple of ways that term is applied.  Then, you can begin to use your understanding of volatility — if you aren’t already — to create or enhance trading or investment strategies that take this critical element into account.

So, what is volatility?  Volatility is simply the relative rate at which the price of a security — be it a stock, market index, exchange traded fund, or option — moves up and down in price.  The way to mathematically determine a security’s volatility is to calculate the standardized standard deviation of a daily change in price of that security.

What?  If you’re not a mathematical person, don’t worry.  The essential point to remember is that when you are measuring the volatility of a security, you are comparing the movements of that security to the manner in which it has moved in the past.

The best way to understand volatility in reference to a security is to think of it in terms of price movement.  For example, if the price of a security moves up and down relatively quickly over a short period of time — or trades within a wide range over a short time frame — that security is said to have a high degree of volatility.  Conversely, a security that remains within a relatively narrow range is considered to have a low level of volatility.

One way investors can use volatility is by using it as a measure of the types of holdings they wish to own in their portfolios.  Why is this helpful?  Just think for a moment…

Let’s say you are an investor who is somewhat risk averse.  You want to own a diverse group of stocks in order to achieve an adequate rate of return, but you don’t want to take on undue risk.  Let’s assume you’ve already done one thing to lower your risk — diversified your holdings among different stocks, presumably in different industries.

But there’s something else you can do.  You can further limit your risk — or at least attempt to — by selecting stocks for your portfolio with a lower-than-average degree of volatility.

Why a lesser degree of volatility?  Because the smaller the range that a security trades within, or the more stable it is, the lesser degree of risk it is perceived to contain.

Now, generally the lesser risk you take, the smaller your profit potential.  But remember, we’re talking about a risk adverse investor here.

So, what’s average?  And how do you determine risk levels?  There’s a metric that answers both those questions.  And it’s one that measures volatility.

It’s called beta.  Beta is a quantitative measure of the volatility of a given security in relation to the S&P 500.  The movement of a stock over the past five years is evaluated against a 1% movement — up or down — in the S&P 500.  A stock with a beta of one is considered to have a level of volatility similar to the S&P 500.

The higher a stock’s beta, the more volatile — and hence the more risky — it is considered to be.  So, a stock with a beta greater than one is more volatile — and judged to contain more risk — than the S&P 500.  Conversely, a stock with a beta of less than one is considered to be more stable — i.e., less volatile or risky — than the overall market.

So, if you are an investor who is loath to take on a large degree of risk, in addition to buying several stocks — or a number of mutual funds — across different industries and asset classes, you could also look to fill up your portfolio with shares of companies that sport a beta of less than one.  In that way, in addition to diversifying your holdings, you would also ostensibly be limiting the degree of fluctuation in your investment account.

There are a myriad of other volatility measures as well.  As just one example, those of you who subscribe to MST Trader or one or more of Agora’s other options services are well aware of the importance that volatility plays in evaluating option premiums.  One important measure of determining the relative expensiveness of an options contract is its “implied volatility.”

Implied volatility is a measure of the value of the up-and-down movement of the underlying security — be it a stock, exchange traded fund (ETF), index, or futures contract — that is, imputed as part of the price of the option contract.  Factors that affect the implied volatility of an option include the price of the option, the option’s exercise price, the time remaining until the expiration date, the amount of any dividend to be paid on the underlying security, and the current risk-free rate of return.

As you can see, an understanding of volatility can aid both the trader and the investor.  And I’ve only scratched the surface on this subject.

Now, remember those market pundits I mentioned at the beginning of this column?  I don’t know how well they grasp the concept of volatility.  But I believe when they utter the word “volatility,” they’re referring to yet another metric — the Chicago Board Options Exchange (CBOE) Volatility Index, or VIX.  I’ll discuss that one next time.

Trade well,

Mark Bail
June 06, 2006

So What’s All This Buzz About Volatility? was originally featured in the Penny Sleuth.