Why volatility is important to investors

The stock market may be highly volatile, and the annual, quarterly, and even daily fluctuations of the Dow Jones Industrial Average are large. Although this volatility can bring huge investment risks, if used correctly, it can also bring considerable returns to savvy investors. Even if the market fluctuates, crashes, or soars, there may be opportunities.

Key points

  • Stock market volatility is usually related to investment risk; however, it can also be used to lock in excess returns.
  • Volatility is usually measured by standard deviation, which indicates how closely the stock price gathers around the mean or moving average.
  • A larger standard deviation indicates a higher degree of diversification of returns and greater investment risk.

Volatility definition

Strictly defined, volatility is a measure of the average return or the dispersion of the average return of a security. Volatility can be measured using standard deviation, which indicates how closely stock prices are grouped around the mean or moving average (MA). When prices are closely clustered, the standard deviation is small. When prices are widely distributed, the standard deviation is large.

As described by modern portfolio theory (MPT), for securities, a larger standard deviation indicates a higher degree of return diversification and a higher investment risk.

Market performance and volatility

In a 2020 report, Crestmont Research studied the historical relationship between stock market performance and volatility. In its analysis, Crestmont uses daily average ranges to measure the volatility of the Standard & Poor’s 500 Index (S&P 500). Their research found that higher volatility corresponds to a higher probability of market decline, and lower volatility corresponds to a higher probability of market rise. Investors can use this data on long-term stock market volatility to align their investment portfolios with related expected returns.

For example, when the average daily volatility of the S&P 500 index is low (the first quartile is 0 to 1%), investors have a high probability of obtaining monthly returns of 1.5% and 14.5% (approximately 70% per month). %, about 91% per year) per year.

When the daily average rises to the fourth quartile (1.9% to 5%), the probability of a monthly loss of -0.8% and a full-year loss of -5.1%. The effects of volatility and risk are consistent across the entire range.

Factors affecting volatility

Regional and national economic factors, such as tax and interest rate policies, can significantly promote changes in the direction of the market, greatly affecting volatility. For example, in many countries, when central banks set short-term interest rates for banks’ overnight loans, their stock markets reacted violently.

Changes in inflation trends, coupled with industry and sector factors, will also affect the long-term trends and volatility of the stock market. For example, major weather events in major oil-producing regions may trigger an increase in oil prices, which in turn pushes up the prices of oil-related stocks.

Assess current market volatility

The Cboe Volatility Index (VIX) detects market volatility and measures investor risk by calculating the implied volatility (IV) of the price of a package of put options on the S&P 500 index. A high VIX reading marks a period of higher volatility in the stock market, while a low reading marks a period of lower volatility. Generally speaking, when the VIX rises, the S&P 500 index falls, which usually marks a good time to buy stocks.

VIX aims to be forward-looking, measuring the expected volatility of the market in the next 30 days.

Use options to take advantage of volatility

When volatility increases and the market panics, you can use options to take advantage of these extreme volatility or hedge your existing positions to prevent serious losses. When the volatility is large, whether it is the broader market or the relative volatility of a certain stock, traders who are short on the stock may buy put options on the stock based on the dual premise of “buy high and sell high” and “trend”. Your friend. ”

For example, Netflix (NFLX) closed at $91.15 on January 27, 2016. After more than doubling in 2015, it has fallen 20% so far this year. Traders who are short on the stock can buy a put option of $90 (that is, a strike price of $90), which expires in June 2016. The implied volatility of the put option was 53% on January 27, 2016, and it was quoted at $11.40. This means that Netflix must fall by $12.55 or 14% before the bearish position becomes profitable.

This strategy is a simple but expensive strategy, so traders who want to reduce the cost of long put positions can purchase further out-of-the-money put options, or they can add short put options to cover the cost of long put positions at a lower cost Price holdings, this strategy is called bear market bearish spreads. Continuing to take Netflix as an example, a trader can buy a $80 put option for June at a price of $7.15, which is $4.25 or 37% cheaper than a $90 put option. Otherwise, the trader can construct by buying 90 US dollars put options at 11.40 US dollars and selling or selling 80 US dollars put options at 6.75 US dollars (please note that the buying and selling price of 80 US dollars put options in June is 6.75 US dollars / 7.15 US dollars) The bear market put option spread, the net cost is $4.65.

Bottom line

The higher volatility brought about by the bear market will directly affect the investment portfolio, and at the same time put pressure on investors, because they watch the value of their investment portfolio plummet. As prices fall, this usually prompts investors to rebalance the weight of the portfolio between stocks and bonds by buying more stocks. In this way, market volatility provides a glimmer of hope for investors who take advantage of this situation.

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