Volatility

What is volatility?

Volatility is a statistical measurement of the rate of price change of a futures contract, security, or other instrument underlying an option.

Volatility trading consists of strategies designed to speculate on changes in the volatility of the market rather than the direction of the market. (Source: CFTC)

Volatility most frequently refers to the standard deviation of the change in value of a financial instrument with a specific time horizon. It is often used to quantify the risk of the instrument over that time period. Volatility is typically expressed in annualized terms, and it may either be an absolute number (5$) or a fraction of the initial value (5%).

For a financial instrument whose price follows a Gaussian random walk, or Wiener process, the volatility increases by the square-root of time as time increases. Conceptually, this is because there is an increasing probability that the instrument's price will be farther away from the initial price as time increases.

More broadly, volatility refers to the degree of (typically short-term) unpredictable change over time of a certain variable. It may be measured via the standard deviation of a sample, as mentioned above. However, price changes actually do not follow Gaussian distributions. Better distributions used to describe them actually have "fat tails" although their variance remains finite. Therefore, other metrics may be used to describe the degree of spread of the variable. As such, volatility reflects the degree of risk faced by someone with exposure to that variable.

Historical volatility is the volatility of a financial instrument based on historical returns. This phrase is used particularly when it is wished to distinguish between the actual volatility of an instrument in the past, and the current volatility implied by the market.

Volatility is often viewed as a negative in that it represents uncertainty and risk. However, volatility can be good in that if one shorts on the peaks, and buys on the lows one can make money, with greater money coming with greater volatility. The possibility for money to be made via volatile markets is how short term market players like day traders hope to make money, and is in contrast to the long term investment view of buy and hold.

It is also possible to trade volatility directly, through the use of derivative securities such as options.

Volatility does not imply direction. (This is due to the fact that all changes are squared.) An instrument that is more volatile is likely to increase or decrease in value more than one that is less volatile.

For example, a checking account has low volatility. It won't lose 50% in a year but neither will it gain 50%.

It's common knowledge that types of assets experience periods of high and low volatility. That is, during some periods prices go up and down quickly, while during other times, they can seem to move almost not at all for a long time.

Periods when prices fall quickly (a crash) are often followed by prices going down even more, or going up by an unusual amount. Also, a time when prices rise quickly (a bubble) may often be followed by prices going up even more, or going down by an unusual amount.

The converse is, 'doldrums' can last for a long time as well.

Most typically, extreme movements do not appear 'out of nowhere'; they're presaged by larger movements than usual. This is termed autoregressive conditional heteroskedasticity. Of course, whether such large movements have the same direction, or the opposite, is more difficult to say. And an increase in volatility does not always presage a further increase--the volatility may simply go back down again. (Source: Wikipedia)