Market Volatility Explained

Volatility might not be a foreign concept to market watchers and traders alike; It has been part of the broader market from the get-go and is even considered a natural part of the financial sector’s movements. However, in the past few months, volatility has increasingly become more of a recurrent motif for the market as it has been making it to the headlines. Accordingly, in this article, we will dive deeper into what volatility means and what causes it and look into the market sectors most affected by it.

TL;DR

• An asset is considered volatile if its price moves rapidly (whether upwards or downwards). 

• Market volatility can be caused by factors such as company news, earnings, politics, economic trends, central bank decisions, and market sentiment. 

• There are two main types of volatility: implied volatility and historical volatility. 

• Historical volatility measures the volatility of an asset in the past.

• Implied volatility measures how volatile investors expect an asset to be in the future.

Market Update: What Is Volatility?

While some might think that volatility solely refers to the rapid price drops of a certain financial asset, it also describes rapid price rises. In other words, volatility pertains to the risk, fear, and uncertainty regarding the potential price swings of a certain financial asset.  

An asset is, therefore, considered volatile if it changes quickly (rapid movements). On the flip side, low volatility is when assets rise or drop very slowly or maintain a certain level of stability over a prolonged period. Volatility is a measure of short-term uncertainty, and traders often utilize it to assess past price variations and predict their future movements.

What Are the Different Types of Market Volatility?

There are two types of volatility: historical volatility and implied volatility. Historical volatility, as its name suggests, is based on past performance and is also referred to as statistical volatility, as it follows the upward and downward trends of a certain asset by measuring the changes over a preset period of time. Hence, historical volatility measures the volatility of an asset in the past. In contrast, implied volatility measures how volatile investors expect an asset to be in the future and can be calculated from the prices of put and call options.

What Causes Volatility?

Volatility can be affected and ignited by a plethora of factors. Below are some of the most common causes behind volatile markets. 

Political and Economic Trends

The development and movement of the macro and microeconomic spheres heavily rely on politics. For example, the effects that the war in Ukraine and the Western sanctions it brought with it on Russian resources took a heavy toll on the market. Various market sectors, from commodities to forex, have experienced high volatility due to this political turmoil. For example, when the war between Russia and Ukraine intensified in February 2022, since Russia is a big oil provider, oil supply fears led oil prices to surge rapidly to new highs.  Another example of how politics and the economy affect volatility is that in times of high inflation, a general risk-averse mood tends to overtake the market, and many market sectors might start losing their lustre. 

Company’s Performance and Representation

Companies with positive earnings releases, successful product launches, or hype around them tend to be successful and increase in value. Similarly, when a company reports earnings below market estimates or has a bad public representation, a scandal or a failed product, its stock tends to depreciate. This, in turn, can affect equity index prices as well.   

Trader Sentiment

While trend-following might seem harmless in most aspects of life, it can sometimes be harmful in the stock market. There’s a risk accompanying trend-following in the market, as those who tend to trade following their emotions (usually novice traders) can often cause market selloffs or buy-crazes, which in turn cause volatility.

Central Bank Decisions

Central banks, like the Federal Reserve and the European Central Bank, can heavily influence trader sentiment and decision-making, which in turn may lead to market volatility. For example, anytime the Fed Reserve's hawkishness increases, fear amongst investors and traders looms, as an aggressive Fed monetary tightening can lead to a recession. For example, high inflation can lead to high interest rates, which can often cause traders to stir away from volatile stocks like tech and opt for safe-haven assets like gold.

Conclusion

To conclude, volatility is an inevitable part of the markets, but understanding it, its different types, and what causes it can be crucial to your potential trading success. 

Moreover, monitoring the factors that can generate market volatility can help you plan and execute your trades more confidently.