What is price volatility? How does it impact you?

XP Invest
September 20, 2019

What is the textbook definition of volatility? It is a statistical measure of the dispersion of returns for a given security or market index (that was literally the Investopedia definition). In case you didn't understand what that meant, the concept of volatility is how 'wildly' does the price of a particular asset move on a daily/weekly/monthly basis. Usually, the more volatile a security is, the riskier it is as well. One thing that you will probably get taught very early on in any finance class is that more risk is usually associated with higher ‘potential’ return, potential being the key word. It's a key word because potential could mean that the price swings up in a big way and you make a huge profit, or swings down and you lose everything you own. A good measure for market volatility is the VIX, or the volatility index. I won't jump into explaining what the VIX is, but for your understanding you can refer to this link.

Differing levels of volatility are also associated with differing risk profiles of investors. Risky investors or day traders will prefer higher volatility commodities such as Oil, Bitcoin or stocks such as Averum Biotech or Tocagen. If you’ve never heard of those stocks its probably because you told your mutual fund manager that you want to grow your savings over a longer time frame. These stocks can have volatility as high as 50% a day. That can be a bit daunting if you’re saving up to buy a house or a car.

Fortunately, if you’ve told your advisor that you’re saving to buy a house or want to invest in something low risk they won’t put your money there (hopefully). But what if you’re not a low risk of investor? Where would you be investing and what kind of assets would you prefer? Well there are several different asset classes, investment products, items within an asset class that can be considered high-risk.

First question, why do traders like volatility. Well quite simply, a very high level of volatility usually means large price movements which create opportunities for day traders to make huge gains (or losses). Let’s explain numerically and let me (selfishly) also throw in the price for NDX/BTC which is a new trading pair available exclusively on XP Invest.

How did I calculate volatility? I took the end of day prices for NDX (Nasdaq 100) from May 1st to September 12th. I then calculated the daily % price changes. Next, I calculated the standard deviation for this range and got 1.23%. Now this is the standard deviation for this sample for this specific date range. I need to get an annual, weekly and monthly volatility for this range. I then did the same thing for Bitcoin, Tocagen, Gold and our own NDX/BTC. The actual annual volatility of NDX could be different. Based on this article by NASDAQ, the NDX volatility for 2018 was 22.40%, if you have a different method for calculating volatility let me know. We can at least use this method as a proxy. Since I used this method to calculate the volatility for NDX, I chose the same across the different assets.

  • For NDX/BTC, I had to remove weekends and public holidays in order to have the same date range and make the calculation. No doubt this would impact the calculations, if you guys know a better way to calculate please let me know.
  • Tocagen-WOW I know. But keep in mind that there were two trading days that had changes of -38.66% and -77.75% which skew it up by a lot.
  • As I'm writing this article the oil prices are spiking on account of the 'Gulf' strike, so if you keep a close on that

As we can observe from the above table, there is no shortage of volatile investment options, or for safer options as well. If you’re an investor that wants some degree of risk but not to the extent that Tocagen or BTC offer, then S&P 500 or Gold could be suitable investment options. Do keep in mind that investing in commodities like Gold come with their own risks. Gold prices are driven by several macro-economic factors and these factors had kept the price of Gold subdued for the last few quarters. Only now, due to the economic uncertainty have we seen a spike in gold prices again.

If you’re someone who primarily invests in just stocks, what kind of companies should you invest in if you’re risk averse. Theoretically, it should be stocks that come under the ‘large cap’ category or blue-chip stocks. One of the reasons is that a ‘blue-chip’ stock is considered to have lower volatility than mid-cap or small-cap stocks. But….(in the world of finance there is always a but) there are always exceptions. For example, GE was one of the original members of the Dow Jones Index and had been there for a long time. But it was eventually replaced by Walgreens due to poor performance, despite being considered a blue-chip stock. Whenever you invest, its always important to keep a close eye on your portfolio (I’d recommend daily) even if you’re not doing any buying and selling. I am laboring this point because I want to make sure when making an investment decision, you're properly informed. To give you an example of a stock with lower volatility you could look at JPM (JP Morgan chase).The monthly volatility for the stock of JP Morgan Chase (JPM) is 5.96% which is closer to Gold or one of the indices that we have listed above. Apple is also considered as a blue-chip but over the last few months it was impacted by political events such as the trade war.

In conclusion, volatility is one of the many factors that you would need to consider when making investment decisions. Studying politics, company fundamentals and technical indicators are all different ways of making investment decisions. Which would you like to read about next?

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Resources

  1. https://www.nasdaq.com/articles/nasdaq-100-higher-volatility-sp-500-myths-and-truths-around-volatility-2018-04-03