Investors and traders assess their strategies and trading systems based on several criteria. The primary ones are potential profitability and risk level. Both depend on the price changes of selected assets or portfolios. The speed and magnitude of such changes are quantitatively assessed by calculating the volatility indicator. So, what is market volatility in simple terms, what does it depend on, and how is it used in trading?

*From this article you will learn:*

*Volatility serves as a crucial metric in trading and investing, providing insights into potential profit margins and risk levels associated with various assets or portfolios.**Traders and investors utilize a range of tools to evaluate volatility, including standard deviation indicators, the VIX index, and channel tools like Bollinger Bands, enabling real-time monitoring and informed decision-making.**Understanding the factors influencing volatility, such as asset liquidity, market expectations, and overall stability, is essential for effectively gauging market dynamics and making strategic trading or investment choices.*

## Understanding Volatility

Volatility, in economics and finance, is considered a statistical measure reflecting the variability of the price of something (in the context of financial markets, of an asset). Simply put, it shows how much the price changes over a certain period of time. For example, if the price during a trading day can deviate in either direction from the average value by 10%, it’s called 10% volatility. If the average price over this period is $10 and the deviation from it is $0.50, it’s called 0.5 dollars or 5% volatility. Volatility is calculated in absolute values (units in which the price is stated) or relative values (in percentages).

In statistics, to obtain an accurate volatility value, formulas for calculating variance or standard (root mean square) deviation are used. Indeed, calculating the simple average deviation would be incorrect. For example, if during a trading period with an average price of $10, its real value first increased to $11 and then decreased to $9, the average deviation would be $0, leading investors to conclude zero asset volatility, while the price range was significant.

To calculate the standard (root mean square) deviation, the following formula is used.

Where:

- N is the number of calculation periods.
- Pi is the asset price for the calculation period.
- Pc is the average asset price over N periods.

For example, to determine hourly volatility, you can take the average price over this interval and use the current prices as minute-by-minute readings. Similarly, you can calculate the average daily volatility using closing prices (or maximum and minimum prices) at each hourly interval.

## Using Volatility Indicator in Trading

Volatility is one of the most important indicators used by virtually all participants in financial markets trading. For example, traders assessing the volatility of an asset over a certain period of time obtain the potential price movement range. Based on this information, one can calculate price movement targets and place protective stop orders. Additionally, knowledge of volatility provides a basis for determining whether an asset is undervalued or overbought, which can serve as a starting point for identifying good entry points into the market.

For investors, understanding volatility is also crucial. This metric is directly related to investment returns and risk. In other words, the higher the volatility, the higher the potential return on the asset, but correspondingly, the higher the risk. That’s why this indicator is called a measure of risk.

In Markowitz’s portfolio theory, annualized volatility is used precisely for this purpose. This value is calculated using the formula mentioned above, where instead of prices, the annual returns of the asset or portfolio are used. The calculation is performed over a historical interval of 5-10 years. The resulting value is then considered a risk indicator for the asset or portfolio.

When selecting assets for trading or investment, qualitative characteristics are used: high or low volatility. For example, it is commonly said that many stocks are low-volatility assets, while currencies, futures contracts, and cryptocurrencies are high-volatility assets. However, in literature or online publications, almost nowhere are the boundaries within which the indicator should be considered low or high specified. There are claims that low volatility is 1-2%, and high volatility is 10% or more, but there is no justification for this, let alone indications of the time frames for which such assessments are valid.

## What Affects Volatility

It is easy to understand that volatility is not a constant value. It can change significantly over time and depends on many factors:

- Asset liquidity. The lower it is, the higher the volatility. That’s why illiquid assets, such as third-tier company stocks or exotic currency pairs, are considered the riskiest.
- Expectations of market participants. This includes significant events, such as corporate earnings reports or macroeconomic indicators. Traders and investors aim to buy or sell assets at the best price ahead of such events, leading to a demand-supply imbalance and sharp price changes. Typically, the less predictable the data that will be released, the higher the volatility before their release.
- Stability of the situation in the country, industry, or company. A stable situation allows predicting future events with a high degree of probability, which, in turn, reduces asset volatility.

Thus, triggers for increased volatility can be real events: corporate reports, macroeconomic indicators releases, increasing or decreasing geopolitical tensions, political and economic events within the country, weather changes, natural disasters, etc.

Volatility spikes can also be provoked by events unrelated to reality, such as rumors, press releases, comments from opinion leaders on social media. For example, some of Elon Musk’s Twitter posts have repeatedly caused increased volatility in the cryptocurrency market. Moreover, today there are other opportunities for external influence on volatility, such as collusion on social media. An example is the GameStop stock story, where the increase in volatility, resulting in billion-dollar losses for hedge funds, was the result of actions by Reddit community members.

Regulators may consider such groundless volatility spikes as price manipulation. If such a decision is made, the initiators may face severe penalties – from large fines to criminal liability.

## Tools for Evaluating Volatility

Certainly, traders can independently assess the volatility of any asset or portfolio at any time. Fortunately, the formula for its calculation is simple, and modern spreadsheet software has standard functions for this purpose. However, such an approach is not always convenient, and traders prefer to see changes in volatility in real-time. To do this, ready-made tools can be used:

- VIX (CBOE Volatility Index). The index is calculated by the Chicago Board Options Exchange and reflects the volatility of the American S&P 500 index. Its increase indicates an increase in volatility and is often used to forecast crises in the US stock market. The real-time change graph is available on almost any portal dedicated to trading and investing.
- Standard Deviation Indicator (StDev), which is included in the delivery list of almost all trading platforms. It shows the standard deviation of the asset price from the moving average over a specified period. It almost completely replicates the statistical definition of the indicator.
- Average True Range (ATR). It uses a different algorithm than StDev, which assesses the range of price fluctuations over the trading period and averages it using moving averages.
- Channel tools that use combinations of moving averages and volatility indicators. These include Bollinger Bands and Keltner Channels. They allow visually assessing the price range, identifying optimal entry points into the market, and setting orders to lock in profits and limit losses.

Thus, volatility is one of the most important indicators. It allows assessing the potential profitability of investments and the level of risks. The magnitude of volatility depends on many factors, changes over time, and can be visually displayed using various indicators.