Volatility in the Financial Markets Explained for Dummies

 

What is a financial market? 

  A financial market refers to a place where the buying and selling of financial instruments (such as stocks, bonds, or commodities) occur. A financial market functions to match buyers and sellers, where buyers aim to buy at the lowest possible price, and sellers attempt to sell at the highest available price.    The value of the financial instruments (also referred to as assets) is typically determined by supply and demand.    There are several types of financial markets, depending on what sellers and buyers want to buy or sell. Put differently, financial markets are categorised according to the type of financial instrument traded.    Types of financial markets are, amongst others: 

• Stock market (also called stock exchange) 
• Bond market 
• Commodities market 
• Futures market 
• Derivatives market  

 

🏆10 Best Forex Brokers in South Africa

What is market volatility? 

  Market volatility indicates the rate at which the price of a given security or asset rises or falls over a certain period. Volatility is usually measured by using the standard deviation (SD) method.    Standard deviation is a measure of the amount of variation or dispersion of a set of values. Market volatility is usually calculated by estimating the standard deviation of the assets’ annualized returns over the specific period,’ according to WallStreetMojo.    A low standard deviation is an indication that the values of the security/financial instrument incline to be close to the mean (also referred to as the expected value). Contrarily, a high standard deviation shows that the values are dispersed over a wider range.    The higher the volatility, the higher the risk associated with the given financial instrument/security.    A concise definition of volatility was formulated by Paul Robinson, a former analyst and strategist of financial markets: ‘In simple terms. Volatility can be defined as the variations in which a market fluctuates. The more an asset’s price moves, the higher the volatility; the less the price moves, the lower the volatility.’    A highly volatile security experiences large swings in value, while a low volatility security has a more stable price.    Market volatility happens when there are recurring fluctuations in the prices of financial instruments, especially in a short time frame.   

Historical examples of market volatility 

  The following are examples of some of the most significant volatility cycles that have occurred in various financial markets since 1929:   

• The Wall Street Crash of 1929 

The Wall Street Crash of 1929, also known as the Great Crash or the Crash of 29, took place in the Northern Hemisphere autumn of 1929. The decline in the market gradually started in September and eventually reached a low point on October 28 (known as ‘Black Monday’), when the Dow Jones Industrial Average (DJIA) lost almost 13% in volatile trading.    Other interesting facts about the Great Crash are: 

• It occurred after a bull market during the roaring twenties and started the Great Depression of the 1930s. 
• The DJIA suffered a loss of 24% on 28 and 29 October, with a two-week realised volatility reaching 127%. 
• The DJIA plunged to its lowest point on July 8, 1932, 89% down from its peak in September 1929. 
• The New York Stock Exchange (NYSE), situated on Wall Street, would only reach its 1929 high in 1954.  

 

• Silver Thursday 1980 

Silver Thursday 1980 refers to March 27, 1980, when the silver price dropped dramatically from its peak of over 50 USD to under 11 USD.    Silver Thursday was preceded by a period during the late 1970s and early 1980s when the three Hunt brothers (Nelson Bunker, Lamar, and William Herbert) attempted to corner the silver market. Some historians described it as one of the most famous market ‘cornerings’ ever.    Examples of how to corner a market are: 

• to acquire enough shares of a company in a niche industry, or 

• to establish a significant commodity position, enabling a trader to manipulate the commodity’s price.  

  The implication of market ‘cornering’ is that the market has been backed into a corner, preventing the market from moving to find sellers and buyers.    However, it was not only the Hunter brothers’ attempt that influenced the silver market negatively. Inflation was rising at a swift pace, while metal hedges were in great demand.    According to estimates, the Hunt brothers had accrued about 33 percent of the global supply of silver that was held privately.   

• Black Monday 1987 

Black Monday 1987, also referred to as the Stock Market Crash of 1987, occurred on 19 October 1987. (Notably, there are other historical events bearing the same name.)    It started in Hong Kong, spread through Asia and Europe, and eventually reached New York.    The Federal Reserve (the central bank of the USA) describes the event as follows: ‘A chain reaction of market distress sent global stock exchanges plummeting in a matter of hours. In the United States, the Dow Jones Industrial Average (DJIA) dropped 22.6 percent in a single trading session, a loss that remains the largest one-day stock market decline in history.’ (Accentuation by the article writer.)    Factors contributing to the Black Monday crash were, amongst others: 

• computerised trading, 
• extremely high speculative excesses, and 
• a new investment product provided by US investment firms referred to as ‘portfolio insurance.’ Portfolio insurance trading strategies ‘included extensive use of options and derivatives and accelerated the crash’s pace as initial losses led to further rounds of selling,’ according to the Federal Reserve. 
• Global Financial Crisis (GFC) 

  The Global Financial Crisis (GFC) (also called the Great Financial Crisis) ‘refers to the period of extreme stress in global financial markets and banking systems between mid-2007 and early 2009,’ according to the Reserve Bank of Australia.    The financial crisis spread globally from the USA to other countries via the global financial system.    The consequences of the CFC were, amongst others: 

• Numerous banks around the world suffered large losses and required government support to prevent bankruptcy. 
• Major developed countries experienced their worst recessions since the Great Depression in the 1930s, causing millions of people to lose their jobs. 

  Major causes of the GFC, inter alia, include: 

• Irresponsible banking practices by banks in the USA, which were willing to provide increasingly large volumes of risky loans. 
• Regulation and policy errors. For instance, the regulation of subprime lending was too lax and insufficient. 

 

Types of market volatility 

  There are two types of volatility, namely implied volatility and historical volatility.   

• Implied volatility (IV) 

Implied volatility, also called projected volatility, is one of the key trading tools for options traders, allowing them to estimate the future volatility of a stock or index based on the prices of options. For instance, a security that trades between 100ZAR and 150ZAR over a certain period would be regarded as more volatile than a security that trades between 80ZAR and 100ZAR over the same period.   Implied volatility is likely to increase in bear markets, which is when traders assume equity markets are likely to decline.  Keep in mind that implied volatility is not an exact science, but a forward-looking calculation that enables traders to estimate where a market is headed - upward or downward.   

• Historical volatility (HV) 

Contrary to implied volatility (IV), historical volatility (HV), also called statistical volatility, is backwards-looking, calculating the variability of prices that are already known over periods set in advance.   Predetermined periods may be based on intraday changes or on the change from one closing price to the next one. In addition, HV can be gauged in increments varying from 10 to 180 trading days.    Other features of historical volatility (HV) are: 

• HV is interested in how far a price deviates from its average price, upward or downward, within a predetermined period. Hence, HV does not consider market direction. 
• HV is described by Fidelity International as ‘the average deviation from the average price of a security, expressed as a percentage, and is useful when comparing it with other stocks or indices. The higher the percentage, the higher the volatility, and thus the ‘riskier’ the security is perceived to be (and vice-versa).’ (Accentuations by the article writer.) 

   

Measuring market volatility 

 

• Historical volatility 

Historical market volatility can be calculated by determining the standard deviation over a given period, applying the following steps: 

1. Acquire the historical prices for the security for a certain period. 
2. Calculate the average price of the prices collected in step 1. 
3. Determine the difference between the average price and each price in the series. 
4. Square the differences from step 3. 
5. Calculate the sum of the squared differences. 
6. Find the variance by dividing the sum of the squared differences by the total number of historical prices. 
7. Determine the standard deviation by calculating the square root of the variance computed in step 6. 

  For example:    Step 1  The prices of the shares of company XYZ for the past four trading days were as follows:   Day 1: R25.00  Day 2: R27.50  Day 3: R24.75  Day 4: R30.50    Step 2  (R25.00 + R27.50 + R24.75 + R30.50)/4 = R26.94    Step 3  Day 1: 25.00 - 26.94 = -1.94  Day 2: 27.50 - 26.94 = 0.56  Day 3: 24.75 - 26.94 = -2.19  Day 5: 30.50 - 26.94 = 3.56    Step 4  Day 1: (-1.94)2 = 3.76  Day 2: (0.56)2 = 0.31  Day 3: (-2.19)2 = 4.80  Day 4: (3.56)2 = 12.69    Step 5  3.76 + 0.31 + 4.80 + 12.69 = 21.56    Step 6  Variance = 21.56/4 = 5.39    Step 7  Standard deviation = 2.32 (square root of 5.39), indicating that the shares of company XYZ usually deviate from its average share price by R2.32.   

• Implied volatility 

The Chicago Board Options Exchange Volatility Index (commonly referred to as the VIX) is the most used method to measure implied volatility.     The VIX measures the expected volatility of the USA stock market, using the options prices of the S&P 500. The VIX is calculated by combining the weighted prices of the VIX’s put and call options for the next 30 days.   

What causes market volatility? 

There are several reasons why market volatility happens. Furthermore, it is not always easy to correctly predict the reasons.    The following reasons are, amongst many others, why financial markets are prone to volatility: 

• Monetary policy changes by governments 

For instance, higher interest rates or an increase in the rates of capital gains tax. Governments can apply strict tariffs and trade laws. 

• Geopolitical factors 

Examples of these factors are election campaigns in countries, trade wars between countries (for example, the USA and China), and wars like the one in Gaza between Israel and Hamas. 

• Market cycles 

Financial markets are known for periods of ups and downs. It is part of the dynamics involved in the trading of financial instruments.   

How to manage market volatility 

  Some tips to manage market volatility include the following: 

• Be patient and keep to financial goals and a long-term investing strategy. 
• Beware of emotional decisions. 
• Keep in mind that predicting and determining market volatility can be difficult. 

  Note: This article does not constitute investment, financial or trading advice. Its purpose is informative. Please obtain the advice of a professional, reputable, and regulated broker before making trading and investment decisions.

Recommended brokers