What is Volatility in Trading? A quick guide

In trading, the volatility of your chosen assets and the overall market can significantly impact your returns. This updated guide for 2023 helps you understand volatility and how to leverage it on the eToro platform. Let’s dive in!

📊 What is Volatility?

Volatility is a measure of how much an asset’s price fluctuates over time. Assets with many unpredictable price changes are considered highly volatile, while those with smaller price shifts are less volatile. For example, if a price of a share last year was on average $100, but its price went up by $50 and down by as much as $50 too, then it is likely to be very volatile. On the other hand if the price changed only by a small amount, with a maximum of $102 and only as low as $98, it is less volatile than the previous example.

🧲 Why is Volatility Important?

Volatility is directly related to investment risk. Rapid changes in an asset’s price can lead to capital losses, but it can also create opportunities for profit. Understanding volatility is crucial for effective risk management and trading strategy development. If for example you are long in an asset trading at $100 and it is very volatile and goes down to $50, you could loose $50 on this investment if you decide to sell the stock to cash out. If the volatility works in your favor then the value of your asset could increase instead.

📏 How is Volatility Measured?

Volatility is typically measured using the standard deviation of an asset’s returns. One popular tool for assessing volatility is Bollinger Bands, which can be added to an asset’s chart to analyze price movement.

How can you investigate volatility of your chosen asset on eToro?

Often Bollinger Bands are used in practice, which is a tool often used for technical analysis and plots two lines 2 standard deviations around its mean (Simple Moving Average SMA). You can always add them onto an asset’s chart and customize your settings according to your preference, as shown below on the image.

This is how the final result would look like. This indicator is often used to analyze whether the asset is overbought or oversold, depending on how closely the price line moves towards the upper and the lower band. When volatility of an asset increases the two trendlines of Bollinger Bands widen accordingly.

🔍 Types of Volatility

📖 Historical Volatility

Historical volatility measures how spread out the returns of an asset were in the past. It provides insights into the asset’s price fluctuations and can help you make informed trading decisions.

🔮 Implied Volatility

Implied volatility is an indication of what the volatility is expected to be in the future. It’s calculated using complex methodologies based on the prices of financial derivatives, such as options. Options on assets with high volatility tend to trade at higher prices, creating opportunities for profit.

🪙 Example of Volatilty

There are two types of volatilities to consider when talking about asset’s volatility. There is also something called historical volatility of an asset, which measures how spread out the returns of an asset were in the past. Implied volatility on the other hand is an indication of what the volatility is expected to be in the future. It is calculated using quite a complex methodology based on the prices of financial derivatives such as options. Options give you the right to buy or sell an asset at a specific pre-determined price. Options on assets with high volatility tend to trade at higher prices since as the price swings widely there is an opportunity to make a profit from the difference of the asset’s current market price and the price at which it can be sold/bought from the option issuer.

🌪️ What Causes Volatility?

• Company performance: If a company’s performance is unstable, its stock price tends to be volatile.
• Industry changes: Events and trends affecting an industry can impact the volatility of assets within that sector.
• Global and market events: Major worldwide events and economic factors can cause asset prices to fluctuate.

🔗 Volatility and Trader’s Risk Profile

The volatility of your trading position is incorporated into your risk ranking value on eToro. A trader’s risk score takes into account several factors, including the volatility of traded assets.

🌐 Market Volatility

Market volatility measures the overall fluctuation of the market, which can impact individual asset prices.

A common metric of beta is often used to measure how much an asset’s price moves alongside the market as a whole, with S&P 500 with a benchmark for the market. A stock who’s volatility is higher than the market has a beta of above 1 and for the stock who’s price varies less than the market has a lower beta of below 1. These statistics are also available on the platform under the ‘Stats‘ section and can help you relate the performance of your asset to the performance of the market in its price trend analysis.

Risks resulting from market volatility as a whole is often referred to as systematic risk and is caused by all of the market factors that the company itself cannot control. Beta then denotes the extent to which a company is subject to such risk: a high beta means the stock is very affected by the changes in the market and the opposite. This for instance can be a recession that affects the market as a whole.

🏭 Industry/Country Volatility

If you’re focusing on a specific market sector or country, it’s essential to analyze volatility relative to that niche. eToro offers 20 market indices for this purpose.

💹 Volatility in Trading

Understanding volatility’s impact on your investments is crucial for successful trading. Day traders often seek volatile assets to capitalize on short-term price changes, while long-term investors may prefer less volatile stocks for more stable returns.

With this comprehensive guide, you’re now better equipped to navigate the world of trading and make the most of volatility on eToro. Remember to always be aware of the risks involved in trading and enjoy the process! 🚀

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Be warned!

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Author & Expert Trader - Financial Analyst :

My name is Bart Bregman and I am a full-time professional trader with nine years of experience. I specialize in shorter-term trading using technical analysis, and I have extensive experience with Stocks, CFDs, Options, and Crypto trading. I believe that there is no such thing as a bad trade. I'm currently traveling the world as a digital nomad trader. You can follow my journey on Instagram at https://www.instagram.com/bart_bregman/