What is Volatility in Trading? A quick guide

There are a lot of factors to consider in trading and volatility of your chosen assets and the market overall are some of the most important ones. Below you can find an overview of what they are and how to employ them in your trading on the eToro platform.

(NOTE: Before we continue, we have to give a disclaimer that the trading products offered by the companies listed on this website carry a high level of risk and can result in the loss of all your funds. CFDs are complicated instruments that are never guaranteed to provide you supplemental earnings.  In fact, Around 68% of all retail investors experienced a loss while trading CFDs. Make sure to keep this in mind before attempting to use the eToro platform yourself. All the information found on this website is not official trading advice and all practices shown are referenced for the use of the Demo account only.)

What is volatility?

Volatility, statistically speaking, is a measure of how spread or dispersed returns of a certain assets are in comparison to their mean (basically returns’ standard deviation), so how far they fluctuate up and down compared to their average value for a time period. If a financial asset has many unpredictable changes in its price over time in upwards and downwards directions it is considered to be very volatile and the opposite, so assets with only small price shifts are considered to be 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 imortant?

Well volatility is related directly to risk of investing into an asset. How fast a price of an asset changes over time may affect how quickly a trader could face capital losses on their investment. But do bear in mind that volatility and risk are not the same thing but volatility may be one of the causes of investment risk. 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.

Volatility is simply the measure of how much an asset’s price moves up and down while risk is related to the chances of you loosing your capital because of an unfavorable change. They do go hand in hand however as assets with higher volatility means there are more possible price outcomes that can happen and risk then indicates the chance of these outcomes having a negative impact on your investment.

How is it measured?

Volatility of an instrument is essentially the standard deviation of its returns. It indicates how much on average, the price of asset has deviated from its mean over a period of time. It basically statistically measures the dispertion of asset’s returns.

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.

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.

To make an example a bit more clear, let’s consider a call option, which gives the trader who purchased it the right to buy an asset at a specific price, lets say $100 for a share. Price of an option is called its premium, and lets say they paid $10 for this option. Now the company that issues this stock is about to issue a report on its performance, which can be either positive or negative and change greatly the price of this stock (so the stock price is therefore volatile). If the news is positive like the trader hoped for, the price of this stock is going to increase to $150. The trader can then execute their call option, buying the asset for $100 and re-selling it on the market at $150, its current price, thus making a profit of $40 (-$10 paid for option premium -$100 they paid for the asset + $150 they made selling the asset on the market). Had the price gone down in case of bad news, the investor wouldn’t have exercised the option and lost $10 in options premiums. The process of pricing options using for instance the Black-Scholes formula is quite complex and takes this volatility  into account. Based on these prices of options the volatility of asset’s price can be inferred for investors to trade with accordingly. The overall process is quite lengthy but this explanation should have given you a general idea.

What causes volatility of an asset?

1. Company performance. If a company’s performance is not very stable in terms of sales, cash flows or cost performance its stock price tends to be very volatile accordingly. For instance when a company is relatively new and innovative its cash flows and performance may be hard to anticipate and depend on factors it cannot always control, such as sudden competition or loss of sales.
2. Changes in the industry. There are perhaps certain industry changes that affect a group of companies and securities they issue. Considering the oil and  gas industry as an example, which is considered to be one of the most volatile, changes in prices of assets of such companies are highly subjected to changes in global demand and supply, regulations and laws, any bans and sanctions as a result of political conflicts and so on.
3. Global and market events. Major worldwide events (such as recessiona) affect the stock market greatly as well as several economic factors like rapid changes in inflation or interest rates.

Volatility and Trader’s risk profile

The volatility of your trading position is incorporated into the risk ranking value of your profile.

A trader’s risk score is a tailor made statistic which incorpoates many factors of your trading such as leverage and the correlation of your traded positions, but most importantly the volatility of the assets you are trading. Each instrument’s daily swings in price or better said, its volatility,  is calculated and multiplied by 3 to improve the accuracy of estimation up to 99%.

Market Volatility

It is also possible to measure the volatility of a market as a whole which can then impact the volatility of your traded assets. If the whole market goes down it is likely your investments will go down in value too. Because is it virtually impossible to calculate and combine all of the globally traded assets in the world, and many times volatility of a broad index such as S&P 500 is considered instead. This index combines stocks from 500 biggest companies in the United States, with asset allocation proportional to their market capitalization.

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

Perhaps analyzing your asset or portfolio in relation to the entire market would not be indicative if you are focusing on a particular market sector. This may also be applicable to cases when traders focus on a portfolio made up of assets from a particular country, such as China, Australia, Spain and so on. There is a selection of 15 such market indexes available on the platform that could be used for such reference.

Volatility in Trading

It is always a good idea to understand how volatility will affect your investment and how to trade using it. The choice of how to do so may depend on your investment horizon, trading style and the goal of trading; for instance some traders try to make profits off changes in prices that happen every minute thus using volatility into their favor by using appropriate strategies and more volatile assets or sectors. That is why volatile stocks are popular in day trading, with many analytical tools available on the platform to do so.  Whereas other investors focus on long-term returns without paying attention to short-term deviations or focus on less volatile stocks and more relatively ‘stable’ industries, hoping for an overall favorable direction of price movement over time.

Hopefully this article gave you a pretty good understanding what asset and market volatility are and how to employ them while trading on eToro. Beware of the risks in trading and enjoy the process!

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