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STOCK MARKET VOLATILITY

Project report submitted to the Department of Economics

In partial fulfilment of

Masters of Arts (Economics) Course

Name of the Student : Pahwa Khwaish Gulshan

Class & Year of Study : M.A Semester III, 2019

PRN No. : 2015033800005352

Exam Seat No. :

Guided By : Dr. Akash Kumra

Department of Economics

Faculty OF Arts

The Maharaja Sayajirao University of Baroda

Vadodara 390002

September 2019

Marks Total
(Out of 100)

Dissertation Presentation Attendance Consultation


(Out of 50) (Out of 30) (Out of 10) (Out of 10)

Signature of the Guide and Date:

Signature of the Project Co-ordinator:

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Acknowledgement

I have taken endeavor in making the project on “Stock Market Volatility”, and would like to express my
very great appreciation to Professor Akash Kumra for his valuable and constructive suggestions for this
project. Further, I would like to express my special thanks of my gratitude to my professor who gave me the
golden opportunity to do this wonderful project, which also helped me in doing a lot of research and I came
to know about so many new things and I am thankful to him.

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Index

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What is Volatility?

Volatility is a statistical measure of the dispersion of returns for a given security or market index. In most
cases, the higher the volatility, the riskier the security.

Volatility can either be measured by using the standard deviation or variance between returns from that same
security or market index.

In the securities markets, volatility is often associated with big swings in either direction. For example, when
the stock market rises and falls more than one percent over a sustained period of time, it is called a "volatile"
market.

Market volatility can be seen through the VIX or Volatility Index. The VIX was created by the Chicago
Board Options Exchange as a measure to gauge the 30-day expected volatility of the U.S. stock market
derived from real-time quote prices of S&P 500 call and put options. It is effectively a gauge of future bets
investors and traders are making on the direction of the markets or individual securities. A high reading on
the VIX implies a risky market.

A variable in option pricing formulas showing the extent to which the return of the underlying asset will
fluctuate between now and the option's expiration. Volatility, as expressed as a percentage coefficient within
option-pricing formulas, arises from daily trading activities. How volatility is measured will affect the value
of the coefficient used.

Key Takeaways

 Volatility is the statistical measure of dispersion of returns for a given security or index.
 There are many different ways to measure volatility, including beta coefficients, option pricing, and
standard deviations.
 More volatile assets are considered riskier than less volatile assets because the price is expected to be
less predictable.

Volatility Explained

Volatility refers to the amount of uncertainty or risk related to the size of changes in a security's value.

A higher volatility means that a security's value can potentially be spread out over a larger range of values.
This means that the price of the security can change dramatically over a short time period in either direction.
A lower volatility means that a security's value does not fluctuate dramatically, and tends to be more steady.

Market volatility is when the stock market goes up, then goes down, then up again for a day or for several
days. Volatility can be problematic, but it can also be beneficial for investors. It symbolizes a change in the
market, which can leave investors with gains or with losses, depending on the final outcome. Volatility goes
hand in hand with risk - the more volatile the stock market is, the greater the risk for the investor. Stock
market volatility can be caused by a number of things. Price changes such as foreign currency exchange
rates, prices of stocks and bonds, and financial market prices all affect stock market volatility. The stock
market can change from day to day, month to month, or from year to year - this is almost impossible to
predict. Its volatility can also be affected by investors and their level of confidence, because if investors
confidently take risks and purchase stocks, the market succeeds, but when they lose this confidence, it
fails. Uncertainty is another cause, because if investors are unable to predict the future of the market, this
can lead to volatility. Uncertainty may be affected by the media, meaning that if there is negative talk about
a certain stock on the news, investors are less likely to invest in it.

Stock market volatility can because of a lot no of things.


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1. The transactions driven brokers are making the retails & institutional investors to trade, making their
living through commissions. Their recommendations are prompting analysts to guide the decisions of
investments.

2. Change in national economic policy allows short term change in the market movements.

3. Crisis across the economy reacts negatively on the market prices. The more severe the crisis is, the more
severe is the reaction on the market movement.

4. Quarterly reports filed by the trading companies help to determine the movement of the market in the
similar way.

What is volatility in the stock market? How to deal with volatility?

Volatility in the stock market is arguably one of the most misunderstood concepts in investing world. It can
drive the new and novice investors to question their own investment strategies due to short-term fear. So,
from an investor’s point of view volatility in the stock market is an important concept.

What is volatility in the stock market?

Volatility is the range (highest to lowest) of price change a stock experiences over a given period of time. If
the stock’s price stays relatively stable, then it has low volatility. And a highly volatile stock is one that hits
new highs and lows, moves erratically, and experiences rapid increases and dramatic falls in the stock
market. Highly volatile stocks, that move by larger margins can be more profitable on the upside but also
carry a greater risk of loss. Thus, volatility is a measure of risk in the stock market.

Why investors should care about volatility in the stock market?

I. Volatility in the stock market can define position sizing in the investment portfolio.
II. Volatility in the stock market presents opportunities to buy stocks cheaply and sell when overpriced.
III. There is a strong relationship between volatility and market performance. When volatility tends to
decline as the stock market rises and increase as the stock market falls.
IV. When volatility increases, the risk increases too.
V. Volatility in the stock market comes and goes. It may rise suddenly but could take a long time to
come back down again.

Causes of volatility in the stock market

Over the past decade in the Indian stock market, we have seen the crash of 2007-08 all the way to new
record highs for stocks in 2018. And there have been a lot of ups and downs in between. Often, the stock
market is volatile when something unexpected happens. Here are the most common causes of what can lead
to a volatile stock market.

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1. Political developments

It is easy to see why politics play a big factor in the movement of the stock market. After all, the elected
government plays a major role in regulating industries and impacts the economy overall when it makes
decisions on things like new policies, laws, taxes, tariffs, trade agreements, federal spending etc. Everything
from speeches to legislation to elections could cause knee-jerk reactions among investors in the stock
market.

2. Economic indicators

Economic data of any country offers a window into the health of its overall economy. When the economic
indicators are doing well and achieve set targets, the market tends to react positively. And when the set
targets are missed, the markets may tumble. This is why economic reports are often awaited with bated
breath by investors in the stock market.

3. Performance and the public relations of big companies

Sometimes volatility is not market-wide, rather an individual company can see its stock performance take a
hit or climb. And depending on how large is the company, its performance can have a greater effect on the
stock markets.

4. Volatility in the overseas market

The modern economy is more globally connected than ever. It means that what happens in the world has a
major impact on what happens at a domestic level. War, a political coup, regime changes and the like have
high potential to impact trade, Multi-National Corporations (MNCs) and the flow of money along with
investments between countries. So, when there is even a little hint that something might be going to happen
at the international level, it can cause markets to swing at a domestic level.

5. Market correction

When the stock market has been performing exceedingly well for a long time, chances are the stocks are
overvalued – it needs correction and settles down around stable value. A market correction refers to a price
decline of at least 10% of any stock or market index following a temporary upswing in market prices.

How to beat volatility in the stock market?

Here are few strategies to help you beat volatility in the stock market.

1. Ignore Short-Term chaos in the stock market

One of the common methods used in times of market volatility is to stay the course despite the current
overreaction of the stock market. Even though this may seem to be a lazy and counterproductive strategy, it
may insulate you from losses associated with attempting to time the stock market. Virtually, it is impossible
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to time the stock market top to determine when to get out, and just as difficult to discern the bottom of the
market and when to get back in and invest again.

2. Purchase additional stocks

Volatility in the stock market can also create opportunities for an astute investor to use it to their own
advantage. It can provide entry points for those investors whose time horizon of investment is long-term.
Downward market volatility brings in investors who are bullish and believe that the stock market will
perform well in the long-run with the opportunity to purchase additional stocks at lower prices. Increasing
your position portfolio at a discounted price can be a very powerful investment strategy. This thinking must
be also in line with your risk tolerance and overall financial goals.

3. Don’t stop investing

Have a plan in place outlining your financial goals and time horizon before you need it and review it
regularly to ensure it serves you well during all types of market conditions. This will help you navigate
through periods of volatilities when many people are panicking or acting out of fear.

4. Diversification

Always diversify your investment portfolio, do not just put all your eggs in a single basket. Being
diversified is one of the best ways to help manage your exposure to the volatility in the stock market. By
spreading your money out over various asset classes, you are also spreading out your risk from market
conditions, and ensuring your portfolio’s results are not based on the performance of one type of investment
instrument.

Volatility of the Stock Market

One way of reducing the risk of investing in individual stocks is by holding a larger number of stocks in a
portfolio. However, even a portfolio of stocks containing a wide variety of companies can fluctuate wildly.
You may experience large losses over short periods. Market dips, sometimes significant, are simply part of
investing in stocks.

For example, consider the Dow Jones Industrials Index, a basket of 30 of the most popular, and some of the
best, companies in America. If during the last 100 years you had held an investment tracking the Dow, there
would have been 10 different occasions when that investment would have lost 40% or more of its value.

The yearly returns in the stock market also fluctuate dramatically. The highest one-year rate of return of
67% occurred in 1933, while the lowest one-year rate of return of negative 53% occurred in 1931. It should
be obvious by now that stocks are volatile, and there is a significant risk if you cannot ride out market losses
in the short term. But don't worry; there is a bright side to this story.

How Stock Market Volatility Affects Insurance Companies?

The average consumer believes that most of the money that insurance companies collect in the form of
premium ends up in their bank accounts as profits. The reality is that this is not really the case. The reality is
that most of the money, collected from premiums has to be paid back either in the form of claims, operating
expenses or taxes. Hence, if insurance were simply about taking in and giving out money, it would not be a
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very profitable business. The key point to understand is that there is a time lag between when the money is
collected as premium and when it is paid out. Since there is a time lag involved, insurance companies invest
the money they receive from other people and receive investment income on the same. This investment
income forms a significant chunk of income earned by insurance companies. Since a lot of this money is
invested in the stock market, the increasing market volatility has a major impact on the income generated by
insurance companies.

We will try to understand how important investment income is, for insurance companies. We will also try to
analyze the impact that stock markets tend to have on these incomes and therefore on the solvency of
insurance companies.

Profits Are Not Earned From Premiums

Insurance markets across the world have become very competitive. This means that market pressures have
reduced the insurance premiums to the bare minimum. As a result, insurance companies only retain about 8
cents as profit for every dollar that they take in as premium.

According to the Insurance Bureau of Canada, about 55% of the money is spent back to service the claims
which are generated by policyholders. A humungous 21% is the administrative cost which is required to
service the policy. This includes the cost of paperwork which is sent across to the policyholders as well as
the costs required to maintain customer service helplines. Also, since the insurance industry in North
America is heavily taxed, they pay about 16% of the premium received in the form of taxes. As a result,
after deducting all the expenses, insurance companies are left with a measly 8% which they can retain in the
form of profit.

This is not a sustainable situation since insurance companies are taking far too many risks and therefore 8%
is not a fair rate of return. However, this 8% is only the difference between premium collected and money
paid out. As explained above, insurance companies also have a second source of income, i.e. investment
income. In many insurance companies, investment income contributes about 50% to the total profit earned
by insurance companies. The bottom line is that investment income is critical and can make or break the
financials of any insurance company.

Volatility and Investment Income

The funds held by insurance companies are very tightly regulated. These companies are not at liberty to
invest the funds as and when they like. Instead, there are strict guidelines which explain the various sub-
limits which have to be followed while investing this money. For instance, most of the money has to be kept
in ultra-liquid debt funds since it may have to be retrieved quickly. A relatively small amount of funds can
be invested in long term equities. Also, insurance companies may not be permitted to trade in low end penny
stocks. Their investments have to be restricted to blue chip stocks only.

Market volatility affects short term funds in a negative manner. This is because most of the times, market
volatility is the result of rising interest rates in the market. The problem is that a large chunk of insurance
money is held in debt securities. Since the value of debt securities is inversely related to interest rates,
insurance companies lose money. This has a negative impact on the reserves, i.e. the claim paying ability of
the insurance companies. Companies tend to predict these events and invest more money than required.
However, at the end of the day, even the most sophisticated insurance company is making a guess.
Sometimes these guesses do not work out as intended and have a negative impact on the solvency of the
company.

Also, when interest rates rise, the value of stocks also takes a beating. Stocks are where insurance companies
tend to make most of their investment income from. A fall in the value of the stocks reduces the surplus

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available with insurance companies. Since the reserves fall short of the amount required for making claim
payments, many times, surplus amount is divested in order to make good on the promise to pay claims.

Hence the bottom line is that insurance companies are affected by market volatility in two ways. Firstly,
they witness a fall in the reserves that they have held. Secondly, they also see a drastic fall in the surplus
amount that they hold. Insurance companies are built to handle up to moderate shocks in the stock market
and still remain solvent. However, when black swan events occur, and markets lose a large percentage of
their market capitalization overnight, insurance companies may end up being one of the first casualties.Even
as we move in New Year 2019, stock market experts say that a host of factors including upcoming Lok
Sabha Elections and global factors such as crude oil shocks could add to stock market volatility in New Year
2019.

Even as we move in New Year 2019, stock market experts say that a host of factors including upcoming Lok
Sabha Elections and global factors such as crude oil shocks could add to stock market volatility in New Year
2019. Therefore, any short term or medium term investor should avoid investing with short term or medium
term perspective, as; volatility may hurt the overall returns, says Epic Research CEO Mustafa Nadeem. “The
important point here is that post election as it settles down the long term trend remains intact and the overall
bullish nature of the market unfolds itself for long term investors,” he noted.

According to B Gopkumar, ED & CEO, Reliance Securities diversification and quality will be the key for
2019. Quality stocks ensure higher earnings visibility and help generate positive returns during volatile
times, he noted.

“The first half of 2019 is likely to be more challenging than the second half. Market volatility is likely to
reduce after the elections and focus will completely shift towards bottom-up approach. In the second half of
the year, the mid-caps and small-caps are likely to perform better while the first half could be more focussed
on quality, earnings growth and large caps,” Gopkumar said in a note to FE Online.

According to Ajay Bodke of Prabhudas Lilladher, investors must stick to businesses that display solidity in
balance sheets, have less reliance on leverage, generate free cash flows and have high return ratios.
“Diversify your risks across sectors and avoid heavy concentration in one or two sectors as portfolios would
be prone to large drawdowns if these sectors lose momentum. Closely watch liquidity risks as liquidity
vanishes quickly in a turbulent market especially in micro, small and mid-caps,” he added.

Given the major events such as the elections and global markets continue to break important supports there
could be headwinds for the stock markets. So how much can Sensex and Nifty rally? “For Nifty the range
seems to be 12,100 on the upside to 9,400 on the downside. Sensex, on the other hand, may oscillate
between 39,800 to 32,300,” Mustafa Nadeem told FE Online.

How does the stock market affect the economy?

Movements in the stock market can have a profound economic impact on the economy and individual
consumers. A collapse in share prices has the potential to cause widespread economic disruption. Most
famously, the stock market crash of 1929 was a key factor in precipitating the great depression of the 1930s.
Yet, daily movements in the stock market can also have less impact on the economy than we might imagine.
The stock market is not the real economy. Share prices can change for many reasons – such as correcting an
over-valuation and even large falls in share do not necessarily lead to lower growth.

One well-known joke is:

Stock markets have predicted 10 out of the last three recessions.

The point is a rapid fall in share prices, doesn’t necessarily mean the economy is doing badly.
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For example, the stock market crash of 1987, didn’t cause any economic damage in the real economy.
(though it did influence monetary policy). The UK cut interest rates in fear the stock market crash would
cause a recession. Instead, low-interest rates caused an economic boom with rapid rates of economic growth.

The 1987 stock market crash (where shares fell 25% in value) didn’t reflect serious economic problems, and
the world economy continued to grow at a decent pace.

• Also, the fall in share prices 2000 to 2004 was a period of economic growth in the UK – see great
moderation

However, the fall in share prices 2008/09 was reflecting the real economic problems and perhaps contributed
to economic downturn.

Plummeting share prices can make headline news. But, how much should we worry when share prices fall?
How does it impact the average consumer? And how does it affect the economy?

Economic effects of the stock market

1. Wealth effect

The first impact is that people with shares will see a fall in their wealth. If the fall is significant, it will affect
their financial outlook. If they are losing money on shares they will be more hesitant to spend money; this
can contribute to a fall in consumer spending. However, this effect should not be given too much
importance. Often people who buy shares are wealthy and prepared to lose money; their spending patterns
are usually independent of share prices, especially for short-term losses. Also, only around 10% of
households own shares – for the majority of consumers, they will not be directly affected by a fall in share
prices.

The wealth effect is more prominent in the housing market. (e.g. falling house prices affect more
consumers)

2. Effect on pensions

Anybody with a private pension or investment trust will be affected by the stock market, at least indirectly.
Pension funds invest a significant part of their funds in the stock market. Therefore, if there is a serious and
prolonged fall in share prices, it reduces the value of pension funds. This means that future pension payouts
will be lower. If share prices fall too much, pension funds can struggle to meet their promises. The important
thing is the long-term movements in the share prices. If share prices fall for a long time, then it will
definitely affect pension funds and future payouts. This may cause households to have lower pension
income, and they may feel the need to save more in other terms.

3. Confidence

Often share price movements are reflections of what is happening in the economy. E.g. a fear of a recession
and global slowdown could cause share prices to fall. The stock market itself can affect consumer
confidence. Bad headlines of falling share prices are another factor which discourages people from
spending. For example, the stock market falls of 2008/09 reflected the fall in confidence. On its own, it may
not have much effect, but combined with falling house prices, share prices can be a discouraging factor.
However, there are times when the stock market can appear out of step with the rest of the economy. In the
depth of a recession, share prices may rise as investors look forward to a recovery two years in the future.

4. Investment

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Falling share prices can hamper firms ability to raise finance on the stock market. Firms who are expanding
and wish to borrow often do so by issuing more shares – it provides a low-cost way of borrowing more
money. However, with falling share prices it becomes much more difficult.

5. Bond market

A fall in the stock market makes other investments more attractive. People may move out of shares and into
government bonds or gold. These investments offer a better return in times of uncertainty. Though
sometimes the stock market could be falling over concerns in government bond markets (e.g. Euro fiscal
crisis)

How does the stock market affect ordinary people?

Most people who do not own shares will be largely unaffected by short-term movements in the stock market.
However, ordinary workers are not completely unaffected by the stock market.

1. Pension funds. Many private pension funds will invest in the stock market. A substantial and prolonged
fall in the stock market could lead to a fall in the value of their pension fund, and it could lead to lower
pension payouts when they retire. Similarly, if the stock market does well, the value of pension funds could
increase. Even if people don’t own shares, it is quite likely people with a private pension will have some
connection to the stock market.

However, most shares are owned by the richest 10% of income owners. According to this paper on middle-
class wealth, the poorest 90% of income earners – own just 7% of all equity. So a fall in share prices
primarily affects the top 10% of wealthy households.

2. Business investment. The stock market could be a source of business investment, e.g. firms offering new
shares to finance investment. This could lead to more jobs and growth. The stock market can be a source of
private finance when bank finance is limited. However, the stock market is not usually the first source of
finance. Most investment is usually financed through bank loans rather than share options. The stock market
only plays a limited role in determining investment and jobs.

3. Short-termism. It could be argued workers and consumers can be adversely affected by the short-
termism that the stock market encourages. Shareholders usually want bigger dividends. Therefore, firms
listed on the stock market can feel under pressure to increase short-term profits. This can lead to cost cutting
which affects workers (e.g. zero contract hours), or the firm may be more tempted to engage in collusive
practices which push up prices for consumers. It has been argued that UK firms are more prone to short-
termism because the stock market plays a bigger role in financing firms. In Germany, firms are more likely
to be financed by long-term loans from banks. Typically, banks are more interested in the long-term success
of firms and are willing to encourage more investment, rather than short-term profit maximisation.

10 Reasons Volatility Is Good for the Stock Market

Don't panic over stock market moves.

A volatility spike in U.S. stocks in the past couple of months eliminated 2018 gains and left investors uneasy
about the prospects of a bear market. The S&P 500 index is down 10 percent since October 1, while the
CBOE S&P 500 Volatility Index (VIX) jumped 54 percent. Volatility is often used as a gauge of fear in the
market, but Nicholas Colas, co-founder of DataTrek Research, says volatility is healthy for the market.
Colas recently compiled a list of 10 reasons investors should be thankful for the recent whiplash.

Volatility is a wake-up call.

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Colas says there’s no such thing as a free lunch on Wall Street, but the lack of volatility in recent years may
have caused some investors to forget that rule. The S&P 500 roughly tripled since its 2009 lows, and market
volatility has been near record lows throughout most of the past two years of that run. Stretches of relatively
high, predictable returns with no volatility lull investors into a false sense of security, and it’s in these times
that investors tend to make mistakes by taking on too much risk.

Volatility provides feedback for companies.

In a capitalist market, companies are always experimenting with new approaches and new business
strategies, and the free market decides which strategies are winners and which are losers. When the stock
market steadily marches higher no matter what corporations do or how they put their money to work, it can
seem as if all ideas are genius ideas. A bit of market volatility can apply the type of pressure corporations
need to trim the fat and stay focused on their best ideas. These best ideas are the ones that benefit investors
most in the long term.

Volatility evens the playing field.

Colas says periods of volatility give retail investors a fighting chance against high-powered Wall Street
trading algorithms. He says the majority of high-frequency algorithms are tied to past market performance,
and most are heavily influenced by the past 100 days of market activity. Human investors, however, have
the potential to take a longer-term perspective when it comes to the market. Algorithms rely on numbers and
trends, but Colas says long-term investors can recognize subtle shifts in market conditions. Human investors
are also able to consider new and unique information that may not be incorporated into high-frequency
algorithms.

Volatility creates churn.

A look at a longer-term price chart of the S&P 500 reveals periods of short-term volatility in every bull and
bear market. These volatility patches may seem like random noise in the market. But while the daily trading
patterns are often extremely unpredictable during these periods, an important fundamental shift is happening
under the surface. Investors tend to be fearful during periods of volatility and often sell their largest holdings
or rotate out of the best-performing stocks. Colas says these reset periods eliminate short-term traders that
are not committed to the long term.

Volatility is a signal to policymakers.

The market doesn’t only provide feedback to corporate management, Colas says it also provides a real-time
gauge of what investors think of monetary policy, government regulation and political legislation. The stock
market may be the closest thing American policymakers have to a real-time referendum on the political
headlines of the day. When investors believe policymakers have made a misstep that will create risk in the
economy, the first thing they do is sell risky assets, such as stocks. Policymakers are then forced to either
defend their positions to the public or change course.

Volatility keeps excess in check.

One of the most consistent predictors of economic recessions is patches of excess in financial markets, such
as excess in the housing market prior to the most recent U.S. recession. These excesses tend to build up
during periods in which investors see relatively low risk. While stock market volatility is often a signal of a
bursting bubble, Colas says periods of volatility can also keep bubbles from forming in the first place.
Investors may not like periods of volatility derailing potential market booms, but they also help prevent the
subsequent busts from being as destructive.

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Volatility stress-tests financial technology.

For the past 10 years, new ideas in financial technology and money management have been introduced into
an extremely friendly environment. Colas says robo advisors are a prime example of an investing trend that
has largely gone untested since its conception. Almost any investing strategy can make investors money
during a calm bull market. Companies and strategies that have produced huge returns for investors are often
exposed as one-dimensional during times of extreme volatility. At the same time, strategies and technologies
that can handle the volatility stress test are validated and give investors even more confidence in their long-
term viability.

Volatility is a reality check for venture capitalists.

Colas says market volatility forces venture capitalists to take a more realistic approach to valuing startups
and potential initial public offerings. The current bull market has been extremely generous to high-growth
companies, regardless of high valuations, profitability or debt load. Growth companies have a large margin
for error during periods of market prosperity. However, companies that need large amounts of capital to
grow their businesses over time may find that capital hard to come by if lending markets tighten. Colas says
it’s healthy for VC firms to think twice about a company’s valuation before going all-in on an investment.

Volatility encourages active investment.

The rise of exchange-traded funds in the past decade is partially driven by the fact that investors haven’t
needed to be selective about buying only the best stocks to get decent returns. In 2018, a standard passive
S&P 500 index fund finished the year down about 9 percent. The year-end volatility may force funds to
reconsider their holdings and their strategies, and it may force some investors to consider rotating money
away from passive investments and taking a closer look at which stocks are undervalued and which may be
overvalued.

Volatility facilitates functional capitalism.

Colas says the proverbial “invisible hand” of a market is driven in large part by fear of losses, and those
fears are stirred up during periods of market volatility. Without fear of loss, too much risk-intolerant capital
can work its way into high-risk investments. In those instances, extreme measures such as government
bailouts may ultimately become necessary to save the economy. These types of events can also cause
investors to lose faith in the system and keep their money out of the market, and capital investment is the
fuel that a free market economy needs to grow over time.

Why volatility is good for the stock market.

Here are 10 reasons why investors should welcome volatility in the market:

 Volatility is a wake-up call.


 Volatility provides feedback for companies.
 Volatility evens the playing field.
 Volatility creates churn.
 Volatility is a signal to policymakers.
 Volatility keeps excess in check.
 Volatility stress-tests financial technology.
 Volatility is a reality check for venture capitalists.
 Volatility encourages active investment.
 Volatility facilitates functional capitalism.

5 Lessons About Volatility to Learn From the History of Markets


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In 2018, the re-emergence of volatility took many market participants by surprise.

After all, aside from a few smaller, intermittent spikes over the course of the current bull market, volatility
has largely been in a long-term downtrend since the aftermath of the 2008 Financial Crisis.

Whether there is more volatility lurking ahead this year or whether the markets continue to calm, it’s worth
looking at the last century of market history to put these recent bouts of volatility into context.

Learning From the History of Markets

Today’s infographic comes to us from New York Life Investments and it goes back in time to show us that
the volatility experienced in 2018 was neither exceptional or unusual.

Here are five important lessons to learn from it all:

With volatility back on the table again, investors are re-learning what it’s like to cope with a sometimes
tumultuous market.

Higher volatility can be a source of uncertainty for even the most seasoned investors, but a look at historical
data over the last century helps to ease these concerns.

5 Lessons About Volatility

Here are five lessons about volatility that we can learn from the history of markets:

Lesson #1: Volatility isn’t new


Volatility isn’t a new phenomenon – and it’s actually as old as the stock market itself. In fact, if you look at
historical swings in the Dow Jones Industrial Average, you’ll see that many of the biggest ones were more
than 80 years ago.

Lesson #2: Volatility is actually the status quo


In the last century, volatility has been ever-present in the markets, and between 1935 and 2018 the S&P 500
has seen:

 4,563 total days with +/- 1% price movements


 1,094 total days with +/- 2% price movements

That works out roughly to a 1% price swing every trading week – and a 2% price swing every month. Yet,
over this lengthy time period, and after all of that volatility, the S&P 500 has grown by 25,290%.

Lesson #3: Any short-term volatility disappears with a long-term view


Daily price swings can feel like a roller coaster. But if you take a step back and look at the big picture, this
volatility is just a blip on the radar.

For example, if you look at a chart of the S&P 500 from August 1990 to February of 1991, you’ll see that
daily volatility was rampant. But zoom out to a 10-year chart, and these daily or weekly swings are barely
noticeable.

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Lesson #4: Volatility can be easily weathered with a resilient portfolio
Given that volatility has been around forever and that it’s extremely common, that makes it fairly
unavoidable. Therefore, to weather periods of volatility, it is imperative to build a resilient portfolio by
diversifying between different asset classes.

Certain assets are better at weathering periods of volatility than others. Here are some traits to look for:

(a) Low correlation with the market


These assets can zig when others zag, making them a valuable hedge (Examples: Gold, alternative assets,
municipal bonds)

(b) Generates cash flow


When times are uncertain, the market puts extra value on assets that are generating real cash flow
(Examples: Stocks that pay dividends, or bonds that pay interest)

(c) Defensive or non-cyclical


During uncertain times, there are still companies with stocks that will thrive. They are usually bigger
companies with conservative balance sheets and durable competitive advantages. (Examples: Quality stocks
in healthcare, consumer staples, telecoms, REITs, and utilities sectors)

Lesson #5: Volatility reminds us that there is no reward without risk

Investing in stocks comes with risks, but it also comes with the best returns over time:

Asset Type Annualized real return, 1925-2014

U.S. Equities 6.7%

Government Bonds 2.6%

Cash 0.5%

If stocks offer the best long run gains – and volatility is an unavoidable aspect of investing in stocks – then
we must learn to accept volatility for what it is.

Even better, we must learn to build resilient portfolios that can weather any storm, while minimizing these
effects.

What is the best measure of a stock's volatility?

When selecting a security for investment, traders look at its historical volatility to help determine the relative
risk of a potential trade. There are numerous metrics that measure volatility in differing contexts, and each
trader has favorites. Regardless of which metric you utilize, a firm understanding of the concept of volatility
and how it is measured is essential to successful investing.

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Simply put, volatility is a reflection of the degree to which price moves. A stock with a price that fluctuates
wildly, hits new highs and lows, or moves erratically is considered highly volatile. A stock that maintains a
relatively stable price has low volatility. A highly volatile stock is inherently riskier, but that risk cuts both
ways. When investing in a volatile security, the risk of success is increased just as much as the risk of
failure. For this reason, many traders with a high risk tolerance look to multiple measures of volatility to
help inform their trade strategies.

How to Measure Volatility

The primary measure of volatility used by traders and analysts is standard deviation. This metric reflects the
average amount a stock's price has differed from the mean over a period of time. It is calculated by
determining the mean price for the established period, and then subtracting this figure from each price point.
The differences are then squared, summed and averaged to produce the variance.

Because the variance is the product of squares, it is no longer in the original unit of measure. Since price is
measured in dollars, a metric that uses dollars squared is not very easy to interpret. Therefore, standard
deviation is calculated by taking the square root of the variance, which brings it back to the same unit of
measure as the underlying data set.

Calculating Volatility with Average True Range

Chartists use a technical indicator called Bollinger Bands to analyze standard deviation over time. Bollinger
Bands are comprised of three lines: the simple moving average (SMA) and two bands placed one standard
deviation above and below the SMA. The SMA is a moving average that changes with each session to
incorporate that day's changes, and the outer bands mirror that change to reflect the corresponding
adjustment to the standard deviation. Standard deviation is reflected by the width of the Bollinger Bands.
The wider the Bollinger Bands, the more volatile a stock's price within the given period. A stock with low
volatility has very narrow Bollinger Bands that sit close to the SMA.

In the example below, a chart of Snap Inc. (SNAP) with Bollinger Bands enabled is shown. For the most
part, the stock traded within the tops and bottoms of the bands over a six month range between about $12-18
per share.

For a more comprehensive assessment of risk, measure multiple forms of volatility.

Where standard deviation measures a security's price movements compared to its average over time, beta
measures a security's volatility relative to that of the wider market. A beta of 1 means the security has
volatility that mirrors the degree and direction of the market as a whole. This means that if the S&P 500
takes a sharp dip, the stock in question is likely to follow suit.

Relatively stable securities, such as utilities, have beta values of less than 1, reflecting their lower volatility.
Stocks in rapidly changing fields, especially in the technology sector, have beta values of more than 1. A
beta of 0 indicates the underlying security has no volatility. Cash is an excellent example, if no inflation is
assumed.

Related Terms

Volatility Definition
Volatility measures how much the price of a security, derivative, or index fluctuates.

Bollinger Band®

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A Bollinger Band® is a set of lines plotted two standard deviations (positively and negatively) away from a
simple moving average of the security's price.

Stoller Average Range Channel Bands - STARC Bands Definition and Uses
Stoller Average Range Channel Bands (STARC Bands) is a technical indicator that plots two bands around a
short-term simple moving average (SMA). The bands provide an area the price may move between.

Standard Deviation Definition


The standard deviation is a statistic that measures the dispersion of a dataset relative to its mean and is
calculated as the square root of the variance. It is calculated as the square root of variance by determining
the variation between each data point relative to the mean.

Definition Historical Volatility (HV)


Historical volatility is a statistical measure of the dispersion of returns for a given security or market index
realized over a given period of time.

CBOE Volatility Index (VIX) Definition


The CBOE Volatility Index, or VIX, is an index created by the Chicago Board Options Exchange (CBOE),
which shows the market's expectation of 3-day volatility.

3 Volatility Indicators To Help You Trade Effectively

The natural rhythm of the market is not only trending and consolidation but we have to also deal with
different types of volatility. This is where understanding and using volatility indicators can help you trade
more effectively and keep your expectations in check.

Volatile periods in the markets can, in the worst scenario, create wild and sharp swings in the markets which
can make them difficult to trade. We often see extreme volatility after certain news releases and world
events that are extreme in nature and this type of action is easily seen on the chart.

Volatility can be more subtle which we see during extended runs during trending markets and more muted
volatility during the consolidation phase of the market. Each of these types of environments are going to
have different types of market approaches that can be used.

High Volatility

Trending types of systems looking to take advantage of individual swings or longer positions until there is a
change in trend

Breakout systems will take advantage of the volatility that arises when there is a true breakout of a
consolidation

Low Volatility

You can utilize a channel trading system which can be trend line channels or some types of bands

Reversion systems will have you taking positions when markets reach a support or resistance zone the
contains the consolidation

Knowing what phase the market is in will assist you in using the “right tool” for the job. You probably
don’t want to look for longer term trending plays inside of a low volatility consolidation area. You would be

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letting positions ride when the reversal takes place which will have detrimental impact on your trading
account.

Inside of every charting platform, there are tools called volatility indicators that will help you objectively
measure the level of the volatility and it’s important to fully understand the tool you are going to use. Keep
in mind there is no best volatility indicator to use so don’t spend too much time picking and tweaking the
indicator. This applies to any market including Forex and Futures. Apply it to your chart using the standard
setting and that should help you begin to learn how to see volatility in price action.

Using ADX As A Volatility Indicator

The ADX indicator measures the strength of a trend based on the highs and lows of the price bars over a
specified number of bars, typically 14. Generally an ADX crossing of the 20 or 25 levels is considered the
beginning of a trend, either an uptrend or a downtrend. A move down in the ADX is considered to signal the
end of a trend. While the ADX is below 20 or 25 the market is usually in a consolidation.

As long as ADX continues to rise, the trend remains strong, but once it starts to turn down the trend is
weakening. This chart shows a strong trend in place on the left and as price is showing consolidation
periods and no strong price thrusts, the ADX peaks and is s sloping downwards with occasional upturns.
This can objectively show you that the strength of the move has softened and any positions in the price trend
direction should be managed closely.

The far right of the chart we see an upturn from below 20 with an upturn in the ADX. This can indicate the
volatility has returned to the market and you may want to adapt your trading approach to suit the new reality.

ADX Volatility Indicator Rising And Falling

The ADX has two drawbacks that you must be aware of before thinking you’ve found the holy grail of
trading.

It does not indicate the direction of the trend. For that it’s often combined with the Directional Indicator
(+DI and –DI) and as a matter of fact the ADX calculation is based on the DI. It’s easy enough however to
determine the trend visually of with the use of a simple moving average or using the typical trending price
description.

As is the case with most trading indicators the ADX is a lagging indicator. It signals the beginning or end of
a trend after the fact. With proper risk management however that can still allow us to profit from the bulk of
a strong move.

Compare the move of the ADX and the condition of price in the graphic and see what else you can learn
from this chart that may apply to your trading.

ATR – Average True Range Indicator

The ATR measures the true range of the specified number of price bars, again typically 14. The true range
differs from a simple range in that it includes the close of the prior bar in its calculation.

ATR is a pure volatility measure and does not necessarily indicate a trend. It’s quite possible to have volatile
price movement inside a choppy market, as is often the case during an important news event.

The best way to use the ATR is as an indication of a change in the nature of the market. We may see ATR
rise as the market moves from a tight consolidation to a strong trend or we may see ATR fall as the market
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transitions from choppy price action into a smooth, strong trend. This chart shows a couple of examples
where ATR actually falls as price begins to trend, and drops as price enters some choppy consolidation.

Average True Range Not A Direct Reflection Of Price

The ATR has the same drawbacks as the ADX.

It does not indicate direction, so we often see a rising (or falling) ATR in both an uptrend and a downtrend

It is a lagging indicator so it will not catch the very beginning or end of a market transition.

The ATR will not work with range, momentum or Renko bars. Since those are all constant range bars the
ATR will essentially be flat and equal to the constant range.

Using Bollinger Bands As A Volatility Measure

Bollinger Bands are calculated based on the distance of price from a moving average over a specified
number of bars, typically 20. The bands are a fixed number of standard deviations above and below the
moving average, usually two standard deviations. If the price deviation follows a normal distribution that
means that 95% of the normal price fluctuation should be contained within the bands, so a breakout from the
bands implies a move outside of that 95% probability range, or an increase in volatility.

Direction and Volatility

Unlike ADX and ATR, Bollinger Bands indicate both volatility and direction. When price volatility is high
the bands widen, when it’s low the bands tighten. Since it’s possible to have high volatility during
consolidation, typically choppy periods will have wide bands moving sideways, as shown in the highlighted
section labelled “A”.

Bollinger Bands Show Volatility and Direction

When prices transition into a trend, the bands will widen and slope up or down, as shown in the area marked
“B”. As long as price continues to hug the upper or lower band the trend remains strong, but once price
drops away from the bands the market is typically entering a consolidation phase or possibly reversing. You
can clearly see these transitions in the chart but I have highlighted small retraces in price to the moving
average inside the bands.

A simple trading method using the information the Bollinger Bands is telling us could be:

Wait for price to poke outside the bands which indicates a large deviation from normal price hence volatility

Price pulls back to the area around the 20 period moving average (there is no magic here)

Look for a price pattern to indicate a reversal in price

I put together a post on a trading system that uses the same idea but utilizes Keltner Channels for the
volatility and the price pullback measure. I also compare the differences between the two indicators:
Simple Keltner Channel Trading Strategy

Bollinger Bands are an excellent volatility and trend indicator but like all indicators, they are not perfect.
They also lag price action so they will not catch the very beginning or end of a trend. To be fair, you don’t
need to catch the exact turning point but you also don’t want to be taking positions when the move has had a
significant run.
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They can also signal false transitions as shown in the zone marked “A”, where price bounces between the
bands. Although clear in hindsight, at the time price touches the bands it’s not clear if it signals the start of a
trend or the beginning of a fading move or reversal.

Volatility Squeeze

This is not a single volatility indicator but combines both the Keltner Channel and the Bollinger Bands. It
takes full advantage of the difference in the way both indicators measure and react to changes in volatility
which can assist you in determining true breakouts as well as the end of a trending move.

This is a special technique and Netpicks has put together a standalone article on this topic so you can better
understand and utilize this technique called the Bollinger Band squeeze.

Apply These Indicators To Your Trading

These have been just a few volatility indicators commonly available in all charting platforms. I encourage
you to experiment with them and observe them in action. They can be excellent tools to identify market
transitions, and combined with other trending indicators or oscillators could form the basis of a flexible
trading system.

Keep in mind that nothing is perfect and optimizing indicators such as these used for volatility can have you
curve fitting a trading system. This is a dangerous practice and one you should avoid at all costs. You
should read: How To Avoid Curve Fitting During Back Testing which will give you concrete steps you can
take to ensure the viability of a trading system.

Options trading has become very popular over the last few years. Netpicks own “Options Guru” Mike has
put together a hot list of some of the best names to trade in the Options market. You can click here and
download your free hotlist to see what names Mike has been piling up the winners with.

Standard Deviation (Volatility)

Standard deviation is a statistical term that measures the amount of variability or dispersion around an
average. Standard deviation is also a measure of volatility. Generally speaking, dispersion is the difference
between the actual value and the average value. The larger this dispersion or variability is, the higher the
standard deviation. The smaller this dispersion or variability is, the lower the standard deviation. Chartists
can use the standard deviation to measure expected risk and determine the significance of certain price
movements.

Calculation

StockCharts.com calculates the standard deviation for a population, which assumes that the periods involved
represent the whole data set, not a sample from a bigger data set. The calculation steps are as follows:

1. Calculate the average (mean) price for the number of periods or observations.
2. Determine each period's deviation (close less average price).
3. Square each period's deviation.
4. Sum the squared deviations.
5. Divide this sum by the number of observations.
6. The standard deviation is then equal to the square root of that number.

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The spreadsheet above shows an example for a 10-period standard deviation using QQQQ data. Notice that
the 10-period average is calculated after the 10th period and this average is applied to all 10 periods.
Building a running standard deviation with this formula would be quite intensive. Excel has an easier way
with the STDEVP formula. The table below shows the 10-period standard deviation using this formula.
Here's an Excel Spreadsheet that shows the standard deviation calculations.

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Standard Deviation Values

Standard deviation values are dependent on the price of the underlying security. Securities with high prices,
such as Google (±550), will have higher standard deviation values than securities with low prices, such as
Intel (±22). These higher values are not a reflection of higher volatility, but rather a reflection of the actual
price. Standard deviation values are shown in terms that relate directly to the price of the underlying
security. Historical standard deviation values will also be affected if a security experiences a large price
change over a period of time. A security that moves from 10 to 50 will most likely have a higher standard
deviation at 50 than at 10.

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On the chart above, the left scale relates to the standard deviation. Google's standard deviation scale extends
from 2.5 to 35, while the Intel range runs from .10 to .75. Average price changes (deviations) in Google
range from $2.5 to $35, while average price changes (deviations) in Intel range from 10 cents to 75 cents.

Despite the range differences, chartists can visually assess volatility changes for each security. Volatility in
Intel picked up from April to June as the standard deviation moved above .70 numerous times. Google
experienced a surge in volatility in October as the standard deviation shot above 30. One would have to
divide the standard deviation by the closing price to directly compare volatility for the two securities.

Measuring Expectations

The current value of the standard deviation can be used to estimate the importance of a move or set
expectations. This assumes that price changes are normally distributed with a classic bell curve. Even
though price changes for securities are not always normally distributed, chartists can still use normal
distribution guidelines to gauge the significance of a price movement. In a normal distribution, 68% of the

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observations fall within one standard deviation, while 95% fall within two and 99.7% fall within three.
Using these guidelines, traders can estimate the significance of a price movement. A move greater than one
standard deviation would show above average strength or weakness, depending on the direction of the move.

The chart above shows Microsoft (MSFT) with a 21-day standard deviation in the indicator window. There
are around 21 trading days in a month and the monthly standard deviation was .88 on the last day. In a
normal distribution, 68% of the 21 observations should show a price change less than 88 cents. 95% of the
21 observations should show a price change of less than 1.76 cents (2 x .88 or two standard deviations).
99.7% of the observations should show a price change of less than 2.64 (3 x .88 or three standard deviations.
Price movements that were 1,2 or 3 standard deviations would be deemed noteworthy.

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The 21-day standard deviation is still quite variable as it fluctuated between .32 and .88 from mid-August
until mid-December. A 250-day moving average can be applied to smooth the indicator and find an average,
which is around 68 cents. Price moves larger than 68 cents were greater than the 250-day SMA of the 21-
day standard deviation. These above-average price movements indicate heightened interest that could
foreshadow a trend change or mark a breakout.

Conclusion

The standard deviation is a statistical measure of volatility. These values provide chartists with an estimate
for expected price movements. Price moves greater than the Standard deviation show above average strength
or weakness. The standard deviation is also used with other indicators, such as Bollinger Bands. These
bands are set 2 standard deviations above and below a moving average. Moves that exceed the bands are
deemed significant enough to warrant attention. As with all indicators, the standard deviation should be used
in conjunction with other analysis tools, such as momentum oscillators or chart patterns.

Using with SharpCharts

The standard deviation is available as an indicator in SharpCharts with a default parameter of 10. This
parameter can be changed according to analysis needs. Roughly speaking, 21 days equals one month, 63
days equals one quarter and 250 days equals one year. The standard deviation can also be used on weekly or
monthly charts. Indicators can be applied to the standard deviation by clicking advanced options and then
adding an overlay. Click here for a live chart with the standard deviation.

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Weeding Out High Volatility

The Standard Deviation indicator is often used in scans to weed out securities with extremely high volatility.
This simple scan searches for S&P 600 stocks that are in an uptrend. The final scan clause excludes high
volatility stocks from the results. Note that the standard deviation is converted to a percentage of sorts so
that the standard deviation of different stocks can be compared on the same scale.

[group is SP600]
AND [Daily EMA(50,close) > Daily EMA(200,close)]

AND [Std Deviation(250) / SMA(20,Close) * 100 < 20]


For more details on the syntax to use for Standard Deviation scans, please see our Scan Syntax Reference in
the Support Center.

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References:

https://www.kotaksecurities.com/ksweb/Meaningful-Minutes/4-reasons-for-market-volatility-in-India

https://school.stockcharts.com/doku.php?id=technical_indicators:standard_deviation_volatility

https://www.investopedia.com/ask/answers/021015/what-best-measure-given-stocks-volatility.asp

https://www.netpicks.com/volatility-indicators/

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