Volatility

Volatility is a measure of how much and how quickly a price moves. A stock that swings 4% a day is more volatile than one that moves 0.5% a day. Volatility is not the same as direction: a market can be very volatile while going nowhere overall. For traders, volatility is both opportunity and risk. Without movement there is nothing to trade, but the more a price moves, the larger the potential loss on any position.

Ways to measure volatility#

Annualised volatility in plain numbers#

Volatility is usually quoted as an annual percentage. A stock with 32% annualised volatility has a typical daily move of about 32% divided by the square root of 252 trading days, roughly 2%. On about two thirds of days, under the simplifying assumption of normally distributed returns, the move would be within that 2% either way.

Daily volatility ≈ Annual volatility ÷ √252

Why volatility matters#

Position sizing#

The more volatile an asset, the smaller the position needed for the same risk. Many traders size positions using ATR or volatility so that each trade carries similar risk. See Volatility and ATR-Based Sizing.

Stop placement#

Stops placed inside an asset's normal daily noise get hit often for no meaningful reason. Volatility tells you how much room a trade needs.

Option prices#

Higher volatility makes options more expensive, because larger moves increase the chance an option ends up valuable. Options traders trade volatility itself as much as direction. See Volatility Trading.

Costs#

Spreads tend to widen and liquidity thins when volatility jumps, raising trading costs exactly when moves are largest.

How volatility behaves#

• It clusters. Calm periods tend to follow calm periods, and turbulent periods follow turbulent ones. Models such as GARCH capture this.
• It spikes on falls. In stock markets, volatility usually rises more when prices fall than when they rise, which is why the VIX is often called a fear gauge.
• It mean reverts. Extreme readings, very high or very low, tend to drift back towards normal over time.
• It reacts to events. Earnings, central bank decisions and data releases cause scheduled bursts. See Trading Economic Releases.

Volatility and your strategy#

Adjusting size and expectations to the current volatility is a simple habit that removes a lot of avoidable losses.

Frequently asked questions#

Is high volatility good or bad?#

Neither. It creates bigger opportunities and bigger risks. What matters is adjusting position size and stops to the volatility you are trading in.

What is a normal level for the VIX?#

Over its history, the VIX has spent much of its time between roughly 12 and 25. Readings above 30 usually coincide with market stress.

How do I measure a stock's volatility?#

The simplest ways are its average daily percentage move or its ATR. More formally, calculate the standard deviation of daily returns and annualise it.

Sources#

• Wikipedia, Volatility (finance)
• Cboe, VIX index