Volatility has several different applications for trading, investing and predicting the direction of the stock market. If you can predict the direction of the market, you have a good idea what to expect of the economy, so volatility has applications beyond the stock market. Volatility can be expressed in terms of a single stock and its performance relative to other stocks. However, the VIX, or Volatility Index, traded on the Chicago Board Options Exchange has become a major leading indicator of stock market trends and a hint of what is to come in the global economy.
What Beta Means
Some stocks are more volatile than others, meaning they tend to have larger or more frequent price changes than other stocks. In the stock market, this relative volatility is called the stock's beta. A stock that has the same relative volatility as the broad market has a 1.0 beta. More volatile stocks have betas higher than 1.0, and low-volatility stocks have lower than 1.0 betas. Using the beta of a stock allows you to estimate, before buying it, what to expect from its performance.
Trade or Invest
Think of volatility as a measure of risk. The higher the risk, the higher the potential reward or loss. If you are a trader, your goal is to take advantage of the higher potential profits by buying and selling risk, so look for high-beta stocks. If you are a conservative investor, your low-risk portfolio should be made up of low-beta stocks. However, diversifying your portfolio across betas as well as industries can provide protection via the 1.0 and lower-beta stocks yet still allow price appreciation as higher-beta stocks react to events.
Volatility is part of the Black-Scholes option pricing model, which means that the price of an option reflects the expected volatility of the stock. The higher the volatility, the higher the option price. High volatility, or risk, increases the likelihood that the option's price movement will be significant during the time it has left until expiration, whether it is a put or a call option. A favorable move for a put option would be a decline in the price of the underlying stock. A favorable move for a call option would be a rise in the price of the underlying stock. Traders estimate these probabilities constantly, hundreds of times during the trading day, and their estimates form the stock's up or down volatility expectations that go into the pricing of the calls and puts on that stock. If volatility expectations indicate a drop in the price, put options will carry a volatility premium. If expectations indicate a rise in the price, call options will carry a volatility premium.
The CBOE's Volitility Index is called the VIX. It reflects the volatility of a basket of S&P; 500 put and call options. Because the prices of options on an index the size of the S&P; 500 reflect thousands of items of news, hunches and decisions by professional traders and investors, the VIX has proved itself to be a good indicator of the direction of the broad market out to 30 days. When the VIX rises, it is interpreted as a sign that the stock market will experience a pull-back. When the VIX falls, the market is expected to rally. The size of the fluctuation in the VIX is an indication of the extent of the up or down market trend. As global tension increases, even analysts who have nothing to do with investments tend to watch the VIX as an indicator of potential geopolitical and economic changes.
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