What Is Stock Volatility?
Stock volatility is often defined as big swings in price, but technically the volatility of a stock refers to how much its price tends to vary from the mean. The same is true of stock market volatility; when an index tends to perform a certain percentage above or below the mean, it’s a signal of volatility.
Generally, the higher the volatility of a stock, the more risk an investor incurs when they purchase or hold it. But volatility can also provide opportunities for some investors.
How to Measure Stock Volatility
There are a handful of ways to measure stock volatility. Each metric gives investors different information, and a different view of stock market fluctuations.
Standard Deviation
Standard deviation is a common stock volatility measure; it refers to how far a stock’s performance varies from its average. Investors often measure an investment’s volatility by the standard deviation of returns compared with a broader market index or past returns. Standard deviation measures the extent to which a data point deviates from an expected value, i.e. the mean return.
Beta
Beta is another way to measure volatility; it captures systematic risk, which refers to the volatility of a security (or of a portfolio) versus the market as a whole.
For example, beta can measure the volatility of a stock versus its benchmark (e.g. the S&P 500 or another relevant index). If a stock or mutual fund has a beta of 1.0, its inherent volatility is no different than the market at large. If the beta of a stock is higher or lower than its benchmark, that indicates higher or lower volatility.
Recommended: How to Find Portfolio Beta
VIX
The Cboe Global Markets Volatility Index, known as the VIX for short, is a tool used to measure implied volatility in the market. In simple terms, the VIX index tells investors how professional investors feel about the market at any given time.
The VIX Index is a real-time calculation that measures expected volatility in the stock market. One of the most recognized barometers of fluctuations in financial markets, the VIX measures how much volatility investing experts expect to see in the market over the next 30 days. This measurement reflects real-time quotes of S&P 500 Index (SPX) call option and put option prices.
Maximum Drawdown
Maximum drawdown, or MDD, is another stock volatility measure, and can give investors a sense of how much downside risk exists for a given stock (though not the risks of the stock market overall). It basically measures the maximum fall in value that a stock has seen in the past, and is reflected in the difference between that maximum trough, and the highest peak in value before its value fell.
You may recognize the terms peak and trough when discussing the business cycle and bull markets, too. MDD is a peak-to-trough calculation, in other words. It’s a simpler calculation than standard deviation, too:
MDD= Trough Value−Peak Value / Peak Value
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Using Standard Deviation to Calculate Volatility
You can use the standard deviation and variance of returns to create a basic measure of stock volatility. This measure captures variance in price changes over a certain period of time, so you can gauge how far from the mean the stock price tends to go (i.e. how volatile it is).
Formula: σ √T = volatility, where:
σ = standard deviation of returns
T = number of time periods
1. To arrive at the variance, imagine a stock that starts in January with a monthly closing price of $10, and adds $1 per month. Month 1 = $10. Month 2 = $11. Month 3 = $12 … and so on, for all 12 months (or whatever time period you choose).
2. Add the stock price for each month, to arrive at a total of $186.
3. Divide $186 by the number of time periods (12 months in this case) to get an average stock price of $15.50 for the year.
4. Subtract the mean ($15.50) from each monthly value; include results that are negative numbers.
5. Square all the deviations (which will also remove negative numbers), and add them together to get the sum ($50.50); divide the sum by the number of time periods (in this case 12) to get a variance of $4.21.
6. Take the square root of $4.21 to get $2.05 = which is the standard deviation for this particular stock. Knowing this provides an important point of comparison for investors, because it indicates whether a stock’s price fluctuations could be within ‘normal’ ranges or too volatile.
Recommended: What Is a Stock?
Types of Stock Volatility
There are two common types of stock volatility that investors use to measure the riskiness of an investment: implied volatility and historical volatility. These two types of volatility are often used by options traders, who make trades based on the potential volatility of the options contract’s underlying asset.
Historical Volatility
Historical volatility (HV), also known as statistical volatility, is a measurement of the price dispersion of a financial security or index over a period of time. Investors calculate this by determining the average deviation from an average price. Historical volatility typically looks at daily returns, but some investors use it to look at intraday price changes.
As the name implies, historical volatility used past performance to assess present volatility. When a stock sees large daily price swings compared to its history, it will typically have a historical volatility reading. Historical volatility does not measure direction; it simply indicates the deviation from an average.
Implied Volatility
Implied volatility (IV) is a metric that captures the market’s expectation of future movements in the price of a security. Implied volatility employs a set of predictive factors to forecast the future changes of a security’s price.
Implied volatility doesn’t anticipate which way prices might move, up or down, only how likely the volatility will be.
What Causes Market Volatility?
The stock market is known for having boom-and-bust cycles, which is another way of describing stock market volatility. And there are numerous factors that can influence market volatility. Here are just a few:
• Company Performance: Regarding individual stocks, events tied to the company’s performance can drive volatility in its shares. This can include countless factors including: earnings reports, a product announcement, a merger, a change in management, and much more.
• Investor Behavior: Long periods of rising share prices tend to drive investors to take on more risk. They enter into more speculative positions and buy assets like high-risk stocks.
In doing so, investors may disregard their own risk tolerance, and make themselves more vulnerable to market shocks. This pattern can lead to market busts when investors need to sell their holdings en masse when the market is shaky.
• Global Events: For instance, the early stages of the COVID pandemic in February and March 2020 created shockwaves in the markets. As economies across the globe shut down, investors began to sell off risky assets, bringing about high levels of volatility in the financial markets.
Governments enacted extraordinary fiscal and monetary stimulus programs to calm this volatility and bring stability to the markets.
But even as these efforts took effect, other global factors — the war in Ukraine impacting energy prices — also took a toll. And federal reserve interest rate increases during 2022 — instituted at the fastest rate in history in an effort to tamper inflation — likewise roiled the markets, causing stock volatility.
• Seasonality: You’ve heard the old saying, “Sell in May and go away.” That’s a reflection of a phenomenon called market seasonality, which means that year in and year out there are certain patterns that tend to occur around the same times.
While seasonality certainly doesn’t guarantee any investment outcomes, some sectors do see more demand and greater production during specific times of year. Summer months tend to impact the travel sector; the fall might see an uptick in school-related consumer goods, and so on.
Depending on the year, this rise and fall of demand can impact volatility for some stocks.
• Market Cycles: In a similar way, markets also have their cycles; these cycles emerge thanks to trends generated by what’s going on in different business sectors. For example, the rapid evolution of AI in 2023 and early 2024 may have sparked a bit of a market cycle in the tech sector, as the demand for certain products and technologies jumped.
That said, it’s difficult to spot a market cycle until it’s over. Sometimes what appears to be a cycle is simply a normal set of fluctuations. But the anticipation or perception of a cycle can drive volatility.
• Liquidity: Other factors that can drive volatility include liquidity and the derivatives market. Stock liquidity is the ease with which an asset can be bought and sold without affecting prices. If an asset is tough to unload and gets sold at a significantly lower price, that could inject fear into the market and cause other investors to sell, ramping up volatility.
Separately, there’s sometimes a debate as to whether equity derivatives — contracts that are based on an underlying asset (e.g. futures and options) — can cause volatility. For instance, in 2020, investors debated whether large volumes of stock options trading caused sellers of the options, typically banks, to hedge themselves by buying stocks, exposing the market to sudden ups and downs when the banks had to purchase or sell shares quickly.
What Causes Stock Prices to Go Up?
As noted, any number of things can cause a stock’s price to go up — be it good or bad news. For instance, geopolitical events can cause certain stocks to appreciate in price, while others may fall. When there’s political instability, some investors seek safer investments and may pile into consumer staple stocks, or investments that track the price of precious metals.
When the economy is faring well, earnings season can be another time during which stock prices go up as companies report positive news to investors, who may, in turn, feel better about the economy overall, which can affect their investing decisions.
What Causes Stock Prices to Go Down?
Just as nearly anything and everything can drive stock prices up, there are countless factors that can likewise drive values down. That can include bad earnings reports from companies, or earnings data that doesn’t live up to expectations. Political or regulatory changes can also spook investors, who may sell certain stocks and drive prices down.
Again: Stock prices can go down for any and every reason, or no reason at all. This is as good a time as any to remind you that there really is no such thing as a completely safe investment.
💡 Quick Tip: How to manage potential risk factors in a self-directed investment account? Doing your research and employing strategies like dollar-cost averaging and diversification may help mitigate financial risk when trading stocks.
How to Manage Volatility When Investing
Let’s imagine that it’s 2007, and an individual has money invested in the U.S. stock market. Unfortunately, this investor is about to face one of the largest stock market crashes in history: The S&P 500 fell by 48% during the crash of 2008-2009.
This sort of dramatic drop in the stock market isn’t typical, and it can be traumatic even for the savviest and most experienced investor. So, the first step to handling stock market volatility is understanding that there will always be some price fluctuation.
The second step is to know one’s risk tolerance and financial goals, then invest, readjust, and rebalance your portfolio accordingly.
Balance Risk and Reward
Generally speaking, higher rewards sometimes come with higher risks. For example, younger investors in their 20s might want to target higher growth options and be open to more volatile stocks. They may have enough time to weather the gains and losses and, possibly, come out ahead over time.
The reverse is true for someone approaching retirement who wants stable portfolio returns. With a shorter time horizon there’s less time to recover from volatility, so investing in lower-risk securities may make more sense.
Some strategies offer ways that more cautious investors might take to mitigate volatility in their portfolios. One way is diversification.
Portfolio diversification involves investing your money across a range of different asset classes — such as stocks, bonds, and real estate — rather than concentrating all of it in one area. Studies have shown that by diversifying the assets in your portfolio, you may offset a certain amount of investment risk and thereby improve returns.
For example: Lower volatility stocks, such as utility or consumer staple companies, can add stability to a stock portfolio. Meanwhile, energy, technology, and consumer discretionary shares tend to be more turbulent because their businesses are more cyclical, or tied to the broader economy.
Another way to diversify one’s portfolio is to add bonds, alternative investments, or even cash. When deciding to add bonds or stocks to a portfolio, it’s helpful to know that the former is generally a less volatile asset class.
This is useful to know if you’re managing your own portfolio, or if you want to try automated investing, where a sophisticated algorithm provides different asset allocation options in pre-set portfolios.
There are a few other things to take into consideration when managing volatility in your portfolio.
Assess Risk Tolerance
A big part of effectively managing stock volatility as it relates to your portfolio is knowing your limits, or, as discussed, your risk tolerance. How much risk can you actually handle when it comes down to it?
Every investor will need to give that question some thought when deciding how to deploy their money.
While bigger risks often come with bigger rewards, when the market does experience a downturn, there’s the outstanding question of whether you’ll stick to your investing strategy or cut and run. Each investor’s risk tolerance will be different, but it’s important to think about how you can actually handle the risk you take on when investing.
Stick to Long-Term Investing Strategies
One way to manage market volatility is to stick to a long-term investing strategy, such as a buy-and-hold strategy. If you stick to long-term investments rather than derivatives or other short-term assets or tools, you can somewhat ignore the day-to-day ups and downs of stock prices, and in doing so you may be able to better weather market volatility.
Avoid Timing the Market
Timing the market, as it relates to trading and investing, means waiting for ideal market conditions, and then making a move to try and capitalize on the best market outcome. But nobody can predict the future, and this is a high-risk strategy.
When seeing stock market charts and business news headlines, it can be tempting to imagine you can strike it rich by timing your investments perfectly. In reality, figuring out when to buy or sell securities is extremely difficult. Both professional and at-home investors make serious mistakes when trying to time the market.
Consider Dollar-Cost Averaging
Dollar cost averaging is essentially a way to manage volatility as you continue to save and build wealth. It’s a basic investment strategy where you buy a fixed dollar amount of an investment on a regular cadence (e.g. weekly or monthly). The goal is not to invest when prices are high or low, but rather to keep your investment steady, and thereby avoid the temptation to time the market.
That’s because with dollar cost averaging (DCA) you invest the same dollar amount each time. When prices are lower, you buy more; when prices are higher, you buy less. Otherwise, you might be tempted to follow your emotions and buy less when prices drop, and more when prices are increasing (a common tendency among investors).
How Much Stock Volatility Is Normal?
The average stock market return in the U.S. is roughly 10% annualized over time, or about 6% or 7% taking inflation into account.
When looking at nearly 100 years of data, as of the end of July 26 2023, the yearly average stock market return was between 8% and 12% only eight times. In reality, stock market returns are typically much higher or much lower.
It’s also important to remember that past market performance is not indicative of future returns. But looking at history can help an investor gauge how much volatility and market fluctuation might be considered normal. Since the end of World War II, the S&P 500 has posted 14 drops of more than 20%, including the most recent in 2022 — a dip precipitated by the rapid rise in interest rates.
These prolonged downturns of 20% or more are considered bear markets. While bear markets have a bad name, they don’t always lead to recession, and on average bear markets are shorter than bull markets.
Investing in Stocks With SoFi
Stock volatility is the pace at which the price of a company’s shares move up or down during a certain period of time. Volatility is a complex topic, and it often sparks debate among investors, traders, and academics about what causes it.
While equities are considered an important part of any investment portfolio, they are also known for being volatile, and some degree of turbulence is something most stock investors have to live with.
Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).
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FAQ
Is volatility the same as risk?
In a sense, yes. Volatility is an indicator of risk. So a stock that is highly volatile, with big price changes, is considered riskier than a stock that is less volatile and maintains a more stable price.
Who should buy stocks when volatility strikes?
Certain types of investors, e.g. day traders and options traders, may have strategies that enable them to profit from volatile securities (although there are no guarantees). In some cases, ordinary investors with a very high risk tolerance may want to invest in a volatile stock — but they have to be willing to face the possibility of steep losses.
What is the best stock volatility indicator?
Perhaps the most common or popular one is the VIX. Depending on which way the VIX is trending, it may throw off buy or sell signals to investors. The VIX can be helpful for assessing risk in order to capitalize on anticipated market movements.
What is good volatility for a stock?
Deciding whether the volatility of a certain stock is “good” is a matter of your personal investing style and goals. Some investors may seek out volatile equities if they believe they have a strategy that can capitalize on price fluctuations. Other investors with a long-term view may not mind volatility if they believe the outcome over time will be favorable — while others may opt for as little volatility in their portfolios as possible.
What causes volatility in a stock?
Just about anything can cause stock volatility. Some of the more common causes of volatility are earnings reports or other company news; geopolitical news and developments; or broader economic changes, such as interest rate hikes or inflation.
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