What exactly is market volatility and why do some traders love it?
The term volatility is used in a few different contexts by traders and the financial media. It seems the usage of the term increases when the broader market has been trending lower for a while and the financial media is flashing “Breaking News” alerts across your screen.
More precisely than the financial media’s definition, volatility can be defined as the standard deviation of returns. The returns used to calculate standard deviation are usually from an index like the S&P 500 or Dow Jones Industrial Average.
Another precise way to define volatility is with the CBOE Volatility Index, or VIX. The VIX is a measure of implied volatility, or expected future volatility, of the S&P 500 index. The VIX is a handy way to define and measure volatility because real-time VIX data is available in most trading platforms. And hey, it’s easier to check the chart of the VIX than calculate standard deviation. Plus, standard deviation relies on historical data, which means it’s based on history whereas the VIX is based on future expectations.
When checking the chart of the VIX, traders are looking at the absolute value of the VIX in relation to its historical averages. This analysis can help traders define periods of relative calm in the markets or spot instances of market volatility.
For example, over the last three years, the VIX has seen extended periods when it traded in a range between about 12 and 15. These periods in the VIX coincided with a mostly steady and stable trend higher in the S&P 500. However, there have been many instances when the VIX “spiked” higher over the last three years, moving above 20 and, on a few occasions, trading above 30. There was one instance in August 2015 of the VIX reaching all the way above 50. All these higher spikes in the VIX are one way to precisely define periods of market volatility.
But why do traders love periods of market volatility?
Market volatility generally coincides with an increase in risk. The increase in risk might stem from economic indicators pointing to a recession, or a central bank surprising with a new policy announcement, or a high-profile company issuing an earnings warning.
Increases in risk make it more difficult for all stock market participants to find the fair value of stocks and the broader market. This is when the price discovery process becomes much more fluid and the range of fair values for stocks and the broader market increases. To put it simply, increase in risk causes stock prices and the broader market like the S&P 500 to experience big and frequent price changes.
But the risks causing these big and frequent price changes come with a silver lining. For traders, increased risk means increased potential opportunity. This opportunity comes from more range in price to potentially profit from. For instance, suppose XYZ averages a range of $0.50 from its daily low and high during periods when the VIX is between 12 and 15. But when the VIX jumps to 30, XYZ’s range from daily low to high increases to $1.00. That’s double the movement in price on a daily basis that a trader might seek to profit from. And that’s why traders love market volatility.