What does volatility mean in simple terms?
Volatility measures how much and how quickly the price of an asset changes over a given period. It reflects the frequency and extent of price movements and is a key indicator of risk in the markets. By definition, a high degree of volatility means that a security’s price can vary widely, while low volatility suggests more stable prices.
Analysts typically calculate volatility as the standard deviation of a security’s daily returns over a set period. This statistical value helps investors understand how far an asset’s price can move – up or down – from its average price. The greater the standard deviation, the higher the volatility and, therefore, the range of fluctuation.
In practice, volatility serves as a measure of the risk, price swings or the uncertainties associated with investing in a particular security or market. Investors also use it as a risk metric to assess price stability and estimate the likelihood of price fluctuations. Volatility doesn’t indicate direction, only the strength of price changes.
Two types of volatility
The two best-known types are historical and implied volatility. Their meaning helps investors better assess how prices, markets or shares might behave under different conditions.
Historical volatility: Historical volatility refers to the measurement of an asset’s actual price movements over a past period. It provides a concrete representation of how much and how often prices have fluctuated in the past, offering insights into the market’s range of variation. With this type of volatility, investors can assess the past risk profile of an investment.
Implied volatility: Implied volatility shows how much a financial instrument is expected to fluctuate in the future and is derived mainly from the prices of options. These options give buyers the right to buy or sell an underlying asset such as shares or indices at a specified price within a certain timeframe. Implied volatility reflects the market’s expectations regarding the uncertainty or risk of a security and is a key indicator of what volatility means in a forward-looking context. Analysing implied volatility also offers important insights for options strategies. It helps investors assess whether an option is expensive or cheap compared to the historical volatility of the underlying asset.
In short: While historical volatility measures how much prices have fluctuated around their average in the past, implied volatility is based on market participants’ expectations regarding the future level of fluctuation of the underlying asset (e.g. an index or share).
How does volatility arise?
Volatility arises when prices change significantly and frequently. This is caused by fluctuations in supply and demand, triggered by news, economic developments, interest rates or political events. Investor sentiment also plays a central role, as fear or euphoria can influence the strength of price fluctuations (e.g. through panic selling). The greater a security’s movement around its average value, the higher the volatility. Especially for shares and other underlying assets, this risk metric is an important criterion for assessing the market situation.
How is volatility measured?
To measure volatility effectively, analysts and investors use various tools and indicators that go beyond simply calculating standard deviation. These tools include volatility indices such as the CBOE Volatility Index (VIX), which reflects market expectations regarding future fluctuations – for example in the share price of an underlying asset. In addition, technical analysis tools are used, which show volatility bands like Bollinger Bands that indicate price movements relative to a moving average.
Another method is to analyse option prices to determine implied volatility, which indicates the market’s expectations of future fluctuations. These approaches give investors a comprehensive view of expected market volatility (or of individual securities), as they provide both historical data and market forecasts.
Calculating volatility
To calculate the volatility metric means measuring the extent of an asset’s price movements over a given period. The most commonly used method is calculating the standard deviation of daily price changes or daily returns of a security. This gives investors an objective insight into the price fluctuation range.
Here’s a simple guide on how to calculate volatility:
Collect the daily closing prices of the security for the period you wish to analyse.
Calculate the daily returns: For each day, determine the return by taking the difference between the closing price of the current day and the previous day, then divide this by the previous day's closing price.
Calculate the average of the daily returns: Add up all the daily returns and divide by the number of days.
Calculate the standard deviation of these returns: This measures how far the individual returns deviate from the average. To do this, subtract each daily return from the average, square the result, sum these squared deviations, divide by the number of days minus one and then take the square root of the result.
Determine the annual volatility: To obtain the annual volatility, multiply the daily standard deviation by the square root of 252 (the number of trading days in a year).
Investors don’t calculate implied volatility directly; instead, they derive it from option prices. They analyse the expected range of fluctuation of the underlying asset up to the option’s expiry date. The best-known barometer for representing implied volatility in Germany is the so-called VDAX. VDAX stands for the DAX Volatility Index. Other well-known volatility indices besides the VDAX include the VIX for the S&P 500, the VSTOXX for the EURO STOXX 50 and the MOVE Index for US government bonds.
The VDAX, in this case, provides a statement on the expected volatility of the DAX – over the next 45 calendar days. However, keep in mind that expectations regarding price developments are no guarantee. Past price performance is no indicator of future results.
What does volatility mean in finance?
Volatility is an indispensable concept in the stock market that offers deep insights into market behaviour and stability. What volatility means in finance becomes clear when looking at the stock market. On the exchange, volatility manifests itself through the price fluctuations of securities. A wide range of factors such as economic news, political events and market sentiment can greatly influence stock market volatility. These fluctuations present both risks and opportunities for traders and investors. If investors understand them, they can make better decisions about securities. One should also bear in mind that the volatility index can have a self-fulfilling effect – as more investors respond to it, they may further amplify the expected fluctuations through their behaviour.
The volatility of shares is, for example, a direct measure of the uncertainty or risk associated with a company’s stocks. For day traders and short-term investors, high share volatility often presents opportunities for quick returns. However, it also comes with increased risk. Long-term investors, on the other hand, may need to develop robust risk management strategies to handle such fluctuations.
In contrast to individual shares, ETFs and funds often show lower volatility, as they usually represent diversified portfolios with many different assets. This diversification reduces the unsystematic risk typically associated with individual securities. Nevertheless, ETFs and funds are also affected by market movements and macroeconomic changes, which can influence their volatility.
Cryptocurrencies are considered one of the most volatile asset classes of all. Coins like Bitcoin in particular show how strongly markets can react to news, regulation or market sentiment. It’s therefore important for investors to keep an eye on current data.
View the current Bitcoin price with live data and market statistics and track market developments in real time.
