Market Volatility: A Key Concept Every Trader Must Understand

Why Volatility Is an Unavoidable Matter

For those entering the trading world, price (volatility) is something you’ll encounter in every market, whether it’s stocks, commodities, or currency pairs. Opinions on volatility are often divided into two camps: some traders fear it, while others see it as a golden opportunity for profit.

This volatility actually reflects how much the asset’s price deviates from its average level. Generally, the more frequently and significantly the price changes, the higher the volatility. And when volatility increases, the level of risk also rises accordingly.

What Is Volatility?

Volatility means “price fluctuation” and is a statistical measure showing the rate of price change over a specified period. For long-term investors, volatility might seem like an obstacle, but in reality, it often becomes a driver for investment growth if you understand how to manage it well.

The technical meaning of volatility is measuring how much the price of an asset (such as stocks or currency pairs) fluctuates within a given period, usually expressed as the standard deviation of annual returns.

Difference Between Absolute Volatility and Relative Volatility

When measuring volatility, there are two approaches. The first is Absolute volatility, which measures the percentage of the asset’s absolute change over a period. The second is Relative volatility, which compares the asset’s fluctuation to other assets to see how volatile it is relative to the market.

The Economic Impact of Volatility on Portfolios

When volatility increases, investors must deal with several effects. First, investment values can change rapidly, as prices may spike or drop within a short time. This can affect the overall value of the portfolio and make future financial planning uncertain.

Second, trading costs increase, as transactions involving highly volatile assets often incur higher fees. This can eat into your profits significantly.

How to Measure Market Volatility

1. Standard Deviation (Standard Deviation)

The most common method to measure volatility is using the standard deviation. This tells you how much the price changes tend to deviate from the average. Not only does it indicate the magnitude of the change, but it also provides a framework for understanding the likelihood of specific events occurring.

Traders often use standard deviation to measure volatility over different periods, such as intraday, daily, or over 30-180 days, depending on their trading strategy.

2. VIX Index - “Market Fear Index”

The VIX (Volatility Index) of the Chicago Board Options Exchange is known as the “Fear Index,” measuring market expectations of the S&P 500 price changes over the next 30 days.

Generally, the higher the VIX, the more fearful and uncertain the market is, and options (options) become more expensive. Conversely, a low VIX indicates a calm market.

3. Beta Coefficient

Beta measures the correlation between an asset’s movement and the overall market (such as the S&P 500). An asset with a beta of 1.5 means it tends to move 1.5 times the market’s movement.

However, beta has several limitations. It can change over time, vary depending on the market’s direction (up or down), and sometimes does not fully reflect the overall risk of the asset.

How Many Types of Volatility Are There?

Past Volatility (Historical Volatility)

Historical Volatility (also called Statistical Volatility) measures how much the asset’s price has fluctuated in the past.

When past volatility increases, it indicates a dynamic and changing market. Conversely, when it decreases, it may suggest the market is stabilizing.

Implied Volatility (Volatility Implied)

Implied Volatility is an estimate of future volatility expected by the market, derived from the actual prices of options (options) in the market.

Unlike historical volatility, which looks backward, implied volatility looks forward. It tells you how much traders expect the market to fluctuate in the upcoming period. However, it is not an exact science and cannot be trusted 100%.

Step-by-Step Method to Calculate Volatility

Calculation Steps

1. Gather price data from the period you want to analyze.
2. Calculate the average price by summing all prices and dividing by the number of observations.
3. Find the difference between each price and the average.
4. Square those differences.
5. Sum all squared differences.
6. Calculate the variance by dividing the total by the number of data points.
7. Take the square root of the variance to get the standard deviation.

( Real Calculation Example

Suppose you want to measure the volatility of ABC company’s stock over 4 days, with prices of 10, 12, 9, and 14 units respectively.

Step 1 - Find the average price: )10 + 12 + 9 + 14### ÷ 4 = 11.25 units

Step 2 - Find differences from the average:

• Day 1: 10 – 11.25 = -1.25
• Day 2: 12 – 11.25 = 0.75
• Day 3: 9 – 11.25 = -2.25
• Day 4: 14 – 11.25 = 2.75

Step 3 - Square the differences:

• Day 1: (-1.25)² = 1.5625
• Day 2: (0.75)² = 0.5625
• Day 3: (-2.25)² = 5.0625
• Day 4: (2.75)² = 7.5625

Step 4 - Sum the squared differences: 1.5625 + 0.5625 + 5.0625 + 7.5625 = 14.75

Step 5 - Calculate variance: 14.75 ÷ 4 = 3.6875

Step 6 - Take the square root: √3.6875 ≈ 1.92 units

This result indicates that the stock price of ABC company typically deviates from the average by about 1.92 units.

How Does Volatility Function in the Forex Market?

In the foreign exchange (Forex) market, volatility measures how much the value of currencies changes over time. Like other markets, higher volatility means higher risk, but it also creates opportunities for traders to profit from significant price movements.

( High Volatility Currency Pairs

Emerging market currencies or those with low liquidity tend to have high volatility, such as:

• USD/ZAR
• USD/MXN
• USD/TRY

) Low Volatility Currency Pairs

Major currency pairs with high liquidity usually have lower volatility, such as:

• EUR/USD
• USD/CHF
• EUR/GBP
• NZD/USD

Tips for Forex Trading in a High Volatility Market

Use Technical Indicators for Assistance

Bollinger Bands help identify whether the market is overbought or oversold and assist traders in predicting price reversals.

Average True Range ###ATR### measures volatility in absolute terms, and traders can use it to adjust trailing stops to reduce risk.

Relative Strength Index (RSI) gauges the strength of price changes and indicates whether a currency is overbought or oversold, aiding decision-making.

( Set Stop-Loss Points

Using Stop Loss is always a good practice, especially when trading highly volatile currencies. It prevents you from losing more than you’re willing to risk.

) Follow Your Trading Plan

Successful traders often have a clear plan and strictly adhere to it. Sticking to your trading plan helps you manage market volatility systematically and consistently.

Portfolio Management Strategies for Volatility

Think Long-Term

Investing is not a short-term game. The volatility today or this week may be insignificant if you have a long-term investment plan spanning several years. If you need funds soon, do not invest that money.

View Volatility as an Opportunity

Instead of seeing volatility as a problem, view it as an opportunity. When prices fall, you can buy more shares with the same amount of money.

Maintain Portfolio Balance

When volatility is high, adjust your investment proportions to stay balanced, preparing yourself for sharp price changes.

Brief Summary About Volatility

Volatility means “price fluctuation” and measures how much an asset’s price changes. Assets with high volatility are considered riskier because their prices are less predictable.

Measuring volatility can be done through various methods, such as standard deviation, VIX index, or beta coefficient. Each method has its advantages and limitations.

Successful investors and traders deeply understand volatility and use it as a tool to generate profits rather than fear it. Therefore, learning and practicing will help you master trading in volatile markets.