By Richard Gunderson – By its very nature, stock investment involves dealing with volatility. For many, the term “volatility” has a negative connotation particularly when it pertains to financial assets. The dictionary definition of volatility is readily understood. In the world of stock market investing, the meaning is not as clear. For the person sitting on the sidelines asking “how do I start to invest my money“, the presence of volatility in the stock market looks like “shark infested waters”. For the experienced investor, volatility is often considered a good thing that can be used to the investor’s advantage.
This article will clarify what volatility is all about when investing in stocks.
Definitions:
Webster’s Dictionary defines volatility as “likely to shift quickly and unpredictably; unstable; explosive”.
When it comes to stock investments, there are two forms of volatility: historical volatility and implied volatility.
Historical volatility is considered a measure of stock price swings over time. Large variations in price over time is considered high volatility. Small variations in price over time is considered low volatility.
Implied volatility is the volatility as currently estimated by a stock’s option price. High implied volatility means the market expects the stock to continue to be volatile (ie. to continue to make large moves). Low implied volatility means the market believes the stock price moves will be conservative. In the options world, implied volatility has a bearing on changes to the option value. This is beyond the scope of this article.
One key factor about volatility is that it is not a directional indicator. Whether the volatility is high or low, any measure of volatility is not an indicator of the direction a stock price will move. However, taking other factors into consideration, volatility may help to predict the future direction of movement of a stock’s price.
The Chicago Board Options Exchange defines the Volatility Index (VIX) as “a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Since its introduction in 1993, the VIX has been considered by many to be the world’s premier barometer of investor sentiment and market volatility“. The VIX is used by many investors as a measure of risk and they refer to it as the “investor fear gauge”.
To better understand volatility, we need to look at it from a bigger picture point of view.
Volatility Is A Fact Of Life:
Frank Holmes, CEO and Chief Investment Officer of US Global Investors, recently reported that, “in the past 400 years, there have been 47 major credit currency crises”.
However, we must differentiate volatility from crises. Volatility, in the context of large price variation, exists independently from financial crises. Volatility exists to some degree in all market conditions, independent from crises. In fact, most stocks and stock indexes exhibit consider swings in price variation multiple times every year.
According to Frank Holmes, 70% of the time over the past ten years, the rolling 12 month price action exhibited the following price swings:
- +/- 15%…………..gold bullion
- +/- 19%…………..S&P 500 Index
- +/- 23%…………..Russell 2000 Index
- +/- 40%…………..emerging markets
- +/- 40%…………..gold mining stocks
What causes this major movement in prices? Many factors such as changes in economic policy (regulatory changes, taxes) geopolitical news (wars, rumors of wars, terror), and financial news (unemployment, foreclosures, the bursting of bubbles, corporate news).
As Frank Holmes put it “You have to learn to live with volatility”.
Emotions:
As the stock market, or individual stocks, go through volatile swings up, then down, and back up again, there are many different emotions that surface. As prices move up, investors experience emotions that are increasingly positive. As the price moves down, investors experience emotions that are increasingly negative.
However, consider the fact that investors may be at the peak of positive emotions when stock prices are most vulnerable. The peak of prices is usually the peak of risk. It’s this emotional impact that often causes investors to buy at the top, when they are happiest about their financial investments. Likewise, emotions often cause investors to sell at the bottom when they actually should be buying.
Mean Reversion:
Volatility is evidenced by price swings over time. Because these price swings are cyclical, at some point in time prices will peak and begin moving back down. At another point in the cycle, prices will bottom and begin moving back up. This is related to the concept of mean reversion. Prices will always tend to move toward some mean or average price.
It’s interesting to note that the S&P 500 Index peaked at 1576.09 on October 11, 2007 and it hit bottom at 666.79 on March 6, 2009. The mean between those two extremes is 1121.44. As I write this article, the S&P 500 Index is at 1121.64. The S&P 500 Index has reverted to its mean.
Profit Opportunity:
There is a strong “good news story” regarding volatility. Because volatility produces swings in prices from the mean, to high, to mean, to low, to mean again, investors that understand volatility can make very good profits if they synchronize their investments such that they sell when the price is high and buy when the price is low.
After dropping approximately 58% from October 2007 to March 2009, the S&P 500 Index rose approximately 80% during the 12 month period ending in March 2010. During that upward move, more than 1000 stocks doubled in price. That’s a great example of making volatility work for you.
Is Volatility Getting Worse?
At a July 2010 financial conference, Karim Rahemtulla, Investment Director Mount Vernon Research, reported that “there have been more market events [financial crises] in the past 37 years than there were in the previous 200 years.” His conclusion is that market crashes [crises] will likely continue fairly frequently and we need to recognize them and be equipped to respond to them.
How To Interpret The Volatility Index:
The high of the VIX prior to 2008 was 48. During this time period it was believed that anytime the VIX approached 48, this was a time to buy. In 2008, the VIX broke a record and reached 88. How to interpret this “new peak” will take time before anybody really knows.
Karim Rahemtulla recommended the following new guidelines for interpreting the VIX:
- At 80,…….buy it all
- At 60,…….start buying
- At 40,…….start nibbling
- At 20 to 30, neutral
- Under 20,….get nervous
- Under 15,….start selling
- Under 10,….sell it all
Summary:
Volatility is not new, it’s not bad, and it isn’t something to be feared in the world of stock investments. It is, however, a fact of life. It does need to be respected. Regardless of experience, with some quality training and a good sense of judgment, any investor can make volatility work for them.
About the Author
Richard Gunderson is President of Trader Training Schools. He has 30 years of business and business training experience. His investment training and years of online trading experience have resulted in a solid understanding of the challenges beginners face in learning to invest with minimal risk. For more information, click on learn to invest money.
