While selecting security for investment, traders always look at its historical volatility in order to calculate the relative risk of a potential trade. Various metrics measure volatility in different contexts, and every trader has favorites. Therefore, it is not surprising that understanding the concept of stock price volatility is the key to successful investing.
Significantly, volatility is a reflection of the degree to which price moves. A stock with a price that fluctuates and reaches new highs and lows or moves erratically is viewed as highly volatile.
Additionally, a stock that keeps a relatively stable price has low volatility. A highly volatile stock is riskier; however, that risk cuts both ways. While investing in a volatile security, the chance for success is high as much as the risk of failure. Therefore, most traders with a high-risk tolerance look to multiple volatility measures to help inform their trade strategies.
The main measure of volatility used by analysts and traders is the standard deviation. Standard deviation indicates the average amount a stock’s price has changed from the mean over a while, which is measured by determining the mean price for the set period. The differences are then squared, summed, and averaged.
As the variance is the square’s product, it is no longer in the original unit of measure. Since price is estimated in dollars, a metric that uses dollars squared is not very simple to interpret. Accordingly, the standard deviation is measured by taking the square root of the variance.
Moreover, chartists apply a technical indicator named Bollinger Bands to examine standard deviation. Bollinger Bands are included in three lines: the simple moving average and two bands placed one standard deviation over and under the SMA. The simple moving average is a smoothed out version of the stock’s price history; however, it is slower to respond to changes.
The width of the Bollinger Bands shows the standard deviation. The wider the Bollinger Bands is, the more volatile a stock’s price is. Moreover, a stock with low volatility has very narrow Bollinger Bands that stands close to the SMA.
The next one is Beta, which measures a security’s volatility relative to the broader market. For example, a beta of 1 means the security volatility mirrors the market’s degree and direction. Significantly, if the S&p 500 takes a sharp decline, the stock in question is expected to follow suit and drop by a similar amount.
Additionally, Relatively stable securities, for example, utilities, have beta values of less than 1, showing their lower volatility. Besides, Stocks in the technology sector have beta values of above 1. If Beta stands at 0, it shows that the underlying security has no market-related volatility. Also, cash is a great example if no inflation is expected.
And finally, it has to be mentioned that there are low or even negative beta assets that have large volatility that is uncorrelated with the stock market — for example, gold and long-term government bonds.
A maximum drawdown is another way to estimate volatility. The most considerable historical loss usually gives the maximum drawdown for an asset, calculated from peak to trough, during a particular period. Besides, it is also reasonable to use options to ensure that an investment will now lose more than a certain amount. Most of the investors prefer asset allocations with the highest historical return for a given maximum drawdown.
The purpose of applying maximum drawdown comes from the fact that not all volatility is bad for investors. Massive gains are highly appealing, but they also raise the standard deviation of an investment. It’s essential that there are ways to pursue substantial gains while trying to minimize drawdowns.