In finance, volatility refers to how much the price of an asset tends to fluctuate, either up or down, over a specific period of time. A highly volatile stock or bond can be a profitable investment if caught near a bottom. When you buy near a top, however, the value of such assets can decline far below the acquisition price. While price change and volatility often go hand in hand, the two can also diverge under certain circumstances. Understanding how volatility is measured will benefit every investor.
Financial analysts calculate volatility by measuring how much a stock's price has moved up or down over a specific period of time. When calculating daily volatility, the analyst calculates the percentage price change from one business day to the next. To work out the weekly volatility, the analyst compares the end-of-week price and the resulting up or down movement, in percentage terms, from one week's close to the next. These changes are averaged by calculating a statistical measure known as standard deviation. Calculating standard deviation requires relatively advanced math, and experts use computer programs to speed up the process.
Coverage and Period
What kind of volatility figure the analyst will arrive at depends on the time period and coverage used. Using the daily price changes over the last year will result in a different volatility figure than using monthly figures going back five years, for example. In general, stocks that exhibit a lot of daily or weekly volatility are also highly volatile on a monthly and annual basis. There are exceptions, however. The price of stock A may move more than that of stock B on an average day, and thus the daily volatility of A may exceed that of B. On a weekly basis, however, B may be more volatile. This could occur if stock A's daily up-and-down moves tend to occur in opposite directions, mostly canceling out each other over the course of an average week.
Volatility vs Price Change
Generally, the more volatile the stock, the more its price tends to change over a specific time period. Again, if stock A is more volatile than B on a weekly basis, in any given week, the price of A will likely move up or down more than B. However, volatility does not take into account whether the stock's price has gone up or down. When calculating standard deviation, a 10 percent gain and a 10 percent loss are exactly the same. Therefore, you should never select a stock on the basis of its volatility alone. A and B may have the exact same weekly volatility over the last year, yet the price of one stock may have doubled, while other could have halved during the last 12 months. In other words, the direction of the price change and volatility may diverge.
History May Not Repeat
As with most financial figures, volatility tells you about what the stock has done in the past. While this may hint at the future, tomorrow may also be very different from yesterday. A stock may have exhibited extreme volatility while talks about a merger with a rival were taking place. With the merger now an impossibility, the same stock may stagnate and exhibit very low volatility. Like all measures, the volatility of a financial asset should be evaluated within the right context, especially if major changes have taken place concerning the asset over the recent past.
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