If there is one aspect of trading that new traders should get to grips with before they put their money on the line, it’s market volatility. Although volatility brings tremendous risks, it also creates opportunities for investors who have the knowledge and confidence to capitalise on market turbulence.
This article will cover what market volatility is and introduce the indices that investors can use to better understand the potential price swings of particular investment options.
What is Volatility?
Volatility can be defined as the variance of price changes of a security over a specific period. In the case of the foreign exchange market (forex), it measures the stability of foreign currency prices. The more a currency’s price moves, the higher the volatility – the less the price moves, the lower the volatility.
To the uninitiated, you might assume a volatile market would be one to avoid. However, for online traders, any price movement, whether it’s up or down, is a chance to make a profit. If investors believe the price of a currency will rise, they can open a ‘Buy’ deal. If they believe prices will fall, they can open a ‘Sell’ deal. That’s why any turbulence in the market is viewed as a risk, but also as an opportunity.
Many factors can cause the price of a security to rise and fall. That includes:
- Major political events
- Interest rate changes
- Geopolitical factors
- Economic events
- Decisions made by central banks
- Natural disasters
- Extreme weather conditions
- Changes in taxation policies
- Mergers and acquisitions
When gauging the level of volatility in a securities market, traders tend to work with two metrics: ‘Implied’ and ‘Historical’ volatility.
According to Investopedia:
‘Implied volatility is a metric that captures the market’s view of the likelihood of changes in a given security’s price. Investors can use it to project future moves and supply and demand.’
Importantly, implied volatility does not predict the direction in which the price will swing. Instead, it suggests only the degree to which the price may fluctuate. There are two common acronyms you’ll encounter when familiarising yourself with implied volatility indices: VIX and Cboe.
The VIX index is a popular measure of the stock market’s expectation of the volatility of S&P 500 index options. In simple terms, it’s a reflection of what people feel about the current stability of the market and how it’s likely to behave over the short-term. It is commonly referred to as the ‘fear index’, as it is seen by some investors as a measure of fear and anxiety in the market.
Cboe refers to the Chicago Board Options Exchange, which calculates and updates several volatility indices, including the Cboe volatility index (VIX index). The indices are quoted in percentage points and are leading barometers of future price swings relating to a range of securities. Cboe updates and disseminates the index values continuously during trading hours.
Historical volatility, also known as statistical volatility, gauges the fluctuating price of securities in increments, ranging anywhere from 10 to 180 days. Unlike implied volatility, it’s not forward-looking, which means historical indices are not relied upon quite as much by investors.
However, given the continuity seen across past volatility cycles, historical data still has immense value. It can help traders to understand the behaviour of the markets and offers a blueprint to identify when a volatility event may occur. DailyFX’s timeline of historical volatility cycles gives a good overview of the main historical volatility spikes of the past century.
Combining Implied and Historical Data
Budding traders should combine implied and historical volatility indices to help them establish a detailed picture of the market before they make their move. Historical indices can be used to establish the baseline for a security, while fluctuations in the VIX can define the relative values of option premiums.