What is volatility and how not to lose money because of it

2024 Author: Malcolm Clapton | [email protected]. Last modified: 2023-12-17 03:44

If the investor takes it into account, then he earns more and risks less.

What is volatility

Volatility is the deviation of the price of an asset (stock, bond, option, precious metal, crypto or regular currency) from the average value over a period of time.

Volatility is both historical and expected. The first is said when describing the change in the price of an asset in the past. About the second - when making forecasts for the future.

Also, volatility is low (when the price changes by less than 1–3% per trading day) and high (fluctuations reach 10–15% per day). For example, the shares of the oil company Lukoil for March 6 and 10, 2020 collapsed by 20%:

Over the next month, the company fell another 17%. There were reasons for that: first, the OPEC + agreement on the limitation of oil production broke down, and the World Health Organization announced a pandemic, due to which fuel prices collapsed. As a result, the deal did take place, oil went up a little, and after it the company's shares rose by 38% from the minimum.

There is nothing wrong with high or low volatility - it is just an indicator.

Imagine the sea on which a drakkar is sailing with tough investors on board. In calm water there are only small ripples - it is safe, but the ship is standing still. With low volatility, the same is true: asset prices are quite stable, you won't be able to earn much, but you won't have to lose either.

If a storm starts, the sea will move. Due to this, the drakkar can rush faster, or it can go to the bottom. It all depends on the skill of the captain and on luck. So it is with high volatility: asset prices change sharply, there is a chance to make money, but the risk of losses also increases.

Why you need to consider volatility

Because thanks to this, you will not lose money, but make a profit.

Yes, volatility cannot be changed, but you can make money on it. And both for traders and ordinary investors.

The first benefit from high volatility. They play on any price movement. The main thing is to have a chance to buy at a lower price and sell at a higher price. For this chance, traders pay with the risk of being wrong with the direction of the market.

For example, the shares of the oil company Lukoil collapsed in early March 2020. Traders could take into account the already spreading coronavirus and the uneasy relationship in the OPEC + cartel. If they had guessed the moment of the fall, they could have earned 35% in two weeks, or 2,130 rubles from each share:

Over the next two weeks, traders could also earn 37%, or 1,430 rubles per share. But this is an ideal scenario: price changes are unpredictable, and the points of the lowest and highest prices are difficult to guess. Because of this, a trader can buy an asset at a disadvantageous price, panic and sell at an even more inappropriate price.

For the average investor who is saving up for retirement or an apartment for children, volatility is not important: it's just noise in the long run. It is important to remember this. If a person rushes to sell stocks out of fright or starts thoughtlessly playing on the stock exchange, he will most likely lose money. Just How Much Do Individual Investors Lose by Trading? …

What does volatility depend on?

Primarily from the asset class that stands behind it. Let's dwell on the most popular - securities and currencies: the factors that affect their volatility differ.

When it comes to securities

The volatility of stocks and bonds is influenced by such factors.

1. Company size

The older and larger it is, the more predictable: it will earn so much money, pay such and such dividends, and grow by so many percent. Investors understand how the company will behave, so they do not rush to buy or sell shares en masse, and the volatility is low. And vice versa: a small company can grow rapidly and sharply increase profits, or it can go bankrupt.

For example, stocks in the fast food chain McDonald’s are considered low volatility: it is a large company in the conservative sector that is expected to develop steadily. In January-May 2021, their volatility did not rise above 3% per day, but averaged 1.5-2%:

2. Sector of the economy

FMCG companies, real estate and utilities are rarely volatile: they grow weakly, but they also do not fall sharply. Energy, healthcare, finance, or technology, on the other hand, are advancing rapidly but suffering from volatile prices.

3. State features

Tax policy, the debt burden of governments, reforms and the current dynamics of economic development all affect the company's ability to grow and earn money, and, accordingly, on the income of investors. For example, lower taxes will increase the company's profits, its shares will start buying - and volatility will increase.

4. Type of asset

The characteristics of different assets affect their volatility. Stocks, cryptocurrencies or commodities are influenced by many factors, so their price can vary greatly. Bonds or real estate, on the other hand, are a calmer and more predictable asset.

So, while the market was rushing about 10% per day in the spring of 2020, the volatility of Russian government bonds did not exceed 1.5-2%:

Even the big price drop in the summer of 2018 does not actually exceed 4%. The point is that bonds, unlike stocks, have clear conditions. Investors understand what to expect from an asset. For example, our bond has a maturity date, the months in which the investor will receive payment at a fixed rate are known in advance. At best, the date of dividend payment is known for shares, but no one knows what will happen to their price further.

5. Market expectations and emotions

Investors expect results from companies and states: financial statements, economic statistics and decisions on interest rates. When the reality differs from the forecasts, the markets are worried, the volatility increases.

Twitter stock is highly volatile: it is a relatively small tech company that sometimes falls short of expectations. For example, on April 30 and May 1, 2021, the volatility of its shares exceeded 12% per day. The company published its quarterly report, the earnings disappointed investors:

6. External circumstances

These are unexpected and unpredictable events that change the market environment: announcements of sanctions, terrorist attacks, pandemics, statements by politicians and economic crises. Because of them, some companies lose their chances to make money, others acquire them, and volatility is growing.

When it comes to currency

Currency volatility - fluctuations in its rate. It is influenced by such factors.

1. The structure of the country's economy

Some countries earn money in different places of the planet and in different industries. For example, Chinese businesses sell their products all over the world and are not grouped in any one economic sector. Local crises do not greatly affect the country as a whole. But those countries that depend on one industry or trading partner are at greater risk.

For example, a specific sector is important for the Russian economy - oil and gas. Almost half of the main directions of budgetary, tax and customs-tariff policy for 2021 and for the planning period of 2022 and 2023 of money in the budget comes from it. But if the price of oil soars, then the ruble follows it, gives an example What the trends say. Macroeconomics and Markets. April 2021 Central Bank.

2. Liquidity

This is the ratio of supply and demand, that is, the ability to quickly find a buyer or seller for a specific asset. The more liquidity, the lower the volatility. Developed market currencies like the dollar, euro or yen are liquid: they are used for international trade, and savings are stored in them. The rupee, yuan, and ruble are considered emerging market currencies, with both lower supply and demand.

3. Monetary Regulatory Solutions

The decision of the country's central bank to raise or lower the key rate immediately affects the volatility of the currency: its value rises or falls.

4. External circumstances

They affect not only securities but also currencies.

For example, the ruble may fall in price due to political problems. Since 2014, the ruble has lost 100% against the dollar in several approaches. During this time, several packages of sanctions were imposed on Russia, it was accused of interfering in the US elections, and oil became cheaper several times:

For comparison, the Norwegian krone has risen in price by 33% against the dollar during the same time. Norway's economy also depends on oil, but at the same time both it and the political regime are more stable:

How to find out volatility by odds and indices

You can calculate volatility by observing the market. But investors simplified their task and figured out how to quickly assess volatility in the past and predict it in the future.

If we are talking about the past

Economists have created many indicators of historical volatility, three have taken root among investors:

• ATR, Average True Range, average true range;
• Bollinger lines;
• beta coefficients (β).

The first two are professional indicators used by traders. They customize the formulas of indicators for themselves in special programs, trading terminals.

The ATR indicator shows the degree of price volatility. The mathematical formula calculates the moving average of an asset over time, and this reflects its volatility. Indicator - at the bottom of the image:

Bollinger Bands are somewhat similar indicator, only two of them. They help traders understand the direction and range of price fluctuations:

Average investors who don't need to constantly monitor volatility use the beta. Beta is published in analytical reviews that are made by financial institutions. It can also be found on screener sites - web services that sort promotions by a variety of filters. The most popular free screener for foreign stocks is Marketchameleon, data on Russian companies are available on Investing.

For example, electric vehicle manufacturer Tesla has a beta of 2:

When beta is greater than 1, then the stock is more volatile than the stock market index: the price will move more strongly. If tomorrow the market grows by 10%, then Tesla - twice as much, by 20%. With the fall, it will come out the same.

The opposite example is the gold mining company Polyus, whose beta is −0.03:

If the ratio is below zero, then the market and the company's shares move in different directions, and the shares behave more calmly. If the market falls by 10%, the stock will either stay in place, or even grow slightly. Such assets are called defensive assets.

It is important to remember that beta shows historical volatility: what has happened in the past. This can be guided by, but there is no guarantee that it will be the same in the future.

When it comes to the future

You can estimate future volatility using special stock indices. These are indicators that track the price of a certain group of securities, which can consist of hundreds of positions. For example, the S&P 500 stock market index shows the health of the 500 largest US companies.

The volatility index reflects what investors expect over the next month. The most famous in the world is VIX, which is calculated by the Chicago Board Options Exchange. Analysts take the prices of monthly and weekly options, and then form an index using a complex mathematical formula.

The result is a forecast from tens of thousands of traders. If the value of the index is low, then traders do not expect sharp fluctuations in prices. But if it is high, then prices are likely to fall. What they did in the spring of 2020:

Russia has its own volatility index, RVI, which is calculated by the Moscow Exchange. It shows the expectations from the Russian market, which often coincide with the world ones.

How to calculate volatility yourself

It makes no sense for an unprofessional investor to calculate the expected volatility himself: he needs experience and understanding of the derivatives market. It's easier to examine it in the index.

But the historical volatility can be calculated independently, if you really want to. Any spreadsheet program has a standard deviation function. Let's say we downloaded the results of daily trading in Tesla shares for March 2021, transferred the file to Google Sheets and cleaned it up a bit: we spread the date and share price at which the exchange finished working in different columns. Now we can calculate the historical volatility of the company.

First, we calculate the daily profitability using a simple formula: B2 / B1-1. We stretch it to the end and convert the value to a percentage format:

Knowing Tesla's profitability, we can calculate daily volatility. Mathematicians would say that you need to calculate the standard deviation. We will simply use the STDEV formula, or STDEV - we will take the yield by an interval and again convert it to percent:

It turns out that the automaker has high volatility. Let us remind you that a deviation of 1–3% is considered low.

If you want, we can calculate the monthly volatility, for this we multiply the daily volatility by the root of the number of trading days:

There is a third, more accurate way of measuring historical volatility. It is more suitable for math maniacs, the formula is:

How to manage volatility in your portfolio

Investors manage risk, which shows volatility, through diversification and hedging.

Diversification

It works on the principle of “many eggs, many baskets”: the investor allocates money to different assets that are not highly dependent on each other. The basic set - bonds and stocks, on the distribution of shares of which the income depends.

Buying 75% of bonds and 25% of stocks is safer and more profitable than collecting only "safe" bonds. If an investor wants to earn even more, he needs to increase the Vanguard's Principles for Investing Success share of stocks or other assets: some add gold to the portfolio, others choose ETFs, others invest in real estate or rare sneakers.

All this is a question of personal risk tolerance, and they solve it in different ways.

For example, Yale University has a foundation that is considered an example of risk sharing. It is not easy for a private investor to repeat it: venture investments or company financing require tens and hundreds of thousands of dollars. But it is possible to create something similar. In 2020, Yale's portfolio looked like this:

Asset class	Share in portfolio
Absolute Return Funds (including ETFs)	23, 5%
Venture investments	23, 5%
Financing purchases of other companies	17, 5%
Foreign shares	11, 75%
Real estate	9, 5%
Bonds and currencies	7, 5%
Natural resources: precious metals, land, timber, etc.	4, 5%
American stocks	2, 25%

The problem is that diversification works as long as so good. In falling markets, almost all assets go to: in the spring of 2020, stocks, gold, and the price of real estate collapsed. Those who hedged won.

Hedging

Hedge is a way to hedge against financial risks. This is a type of investment that behaves the opposite of the market: if the stock of a particular company rises, then the hedge position loses in value, and vice versa.

Professional investors insure themselves using futures or options contracts. It's like pending sales and purchase agreements. For example, one investor agrees to sell shares in a month at the price that has been negotiated now. And the other commits to buy it. It looks simple, but in reality they are very complex and expensive tools.

A private investor can insure himself if he opens a short position, short: he borrows assets, sells, and then buys back cheaper. It is dangerous to short without special knowledge, because it is a bet against the whole market, which may not fall.

Inverse ETFs are much safer for the investor. These are the same exchange-traded funds, only they move in the opposite direction and grow in a falling market. It is difficult to buy them in Russia, but soon the Information letter on the admission to public circulation of foreign securities in the Russian Federation, perhaps this will change. The Central Bank proposes to simplify the entry into the Russian market for foreign funds. If the bill is approved, global asset management companies could become more accessible to investors.

Things to Remember

1. Volatility is the volatility of asset prices. With high volatility, the price changes by tens of percent per day. At low it fluctuates within a few percent. The higher the volatility, the higher the risk.
2. Times of high volatility are dangerous for the lay investor. Not confident in strength and knowledge - wait for the markets to calm down.
3. The volatility of a particular asset depends on the country, industry, financial statements, politics, and hundreds of other factors.
4. Investors can calculate volatility themselves, but it is easier to study stock screener sites that publish beta ratios and volatility indices VIX and RVI.
5. The easiest way to curb volatility is to invest on the “many eggs, many baskets” principle: invest in assets that are not highly dependent on each other.