What is stock market volatility?

Stock market volatility definition

Stock market volatility refers to the frequency and size of a market move in an upward or downward direction over a specified period. The larger and more frequent the price move, the higher the volatility. In statistical terms, volatility is the standard deviation of a market's annualised returns over a given period.

When volatility is at a heightened level, it is usually considered to be a sign of increased risk and fear in the market. Volatility is a key input into calculating option prices.

How is market volatility measured?

Standard deviation is by far the most popular measure used by traders to measure volatility. Standard deviation is a way of measuring the size of price moves to try to help determine whether the price will become more or less volatile in the future. The standard deviation of a security is calculated by taking the square root of the variance. Variance measures the dispersion of returns around the mean price of a security.

You can calculate the standard deviation on our platform. Most traders would use a computer program to calculate the standard deviation as it is faster and more accurate, but you can also calculate it by hand using the steps below:

1. Calculate the mean average of the security's historic prices in the defined time period
2. Work out the deviation by calculating the difference between the mean average and each of the prices, then square each of those numbers
3. Add each of these squared numbers together and divide it by the number of prices in the data set. This is known as the variance
4. The standard deviation is the square root of the variance, calculated in step 3 above¹

Chartists use Bollinger Bands to analyse standard deviation over time. Bollinger Bands consist of a moving average, an upper band and a lower band. The two bands determine whether the prices are high or low on a relative basis. When Bollinger Bands are narrow, it suggests the market has been in a sideways or consolidation pattern. When Bollinger Bands widen, it suggests an increase in volatility. As volatility is considered to be cyclical in nature, after a period of low volatility, you can expect to see a period of high volatility. You can combine price breakout levels with Bollinger Bands to trade a volatility breakout strategy.

You can also measure volatility using beta. Beta determines a security's volatility relative to the overall market. Beta can be calculated using regression analysis.

Types of volatility

Implied volatility

Implied volatility is a forward-looking measure that enables you to determine how volatile a security or market is expected to be in the future. The concept gives you a way to calculate the probability of future volatility. It’s measured as a percentage and has a tendency to increase when prices decline. High implied volatility suggests that large price swings may occur.

Beta

Beta measures a stock's volatility of returns relative to the overall market, usually against its relevant benchmark. If the S&P 500 has a beta of 1.0, a constituent stock with a beta greater than 1.0 indicates that the frequency and size of the stock's movement is higher than that of the index. Conversely, a stock with beta that's less than 1.0 will move less than the index.

The VIX

The Volatility Index, created by the Chicago Board Options Exchange (CBOE), is a popular measure of implied volatility and is known as the 'fear gauge'. The VIX measures the expected volatility of the S&P 500 for the following 30 days. It's derived from real-time pricing on the S&P 500 call and put options over a wide range of strike prices. An increase in implied volatility, or a high VIX reading, suggests a more risky or uncertain market and a potential downward move in the S&P 500 index.

Volatility as an intrinsic feature of financial markets

Periods of high volatility are a normal feature in financial markets and should be expected. Volatility can be caused by a number of factors. Geopolitical and macroeconomic events can impact the whole market, while certain incidents may only impact a particular industry, sector or company. Markets are usually fairly calm, with brief periods of above-average volatility.

A great example of a buying opportunity at a time of increased volatility and market weakness came in March 2020 during the COVID-19 pandemic. The S&P 500 fell sharply from nearly 3,400 to below 2,300 at the peak of the pandemic panic, and the VIX exploded higher – from around 15 to 85. However, after the Federal Reserve and the other major central banks took the decision to support their economies with aggressive quantitative easing, the S&P 500 rallied nearly 73% to close at 3,972 by the end of March 2021. The VIX, meanwhile, fell back to around 20.

How to handle market volatility

Traders use breakout strategies and scalping (entering buy and sell orders over the short term) during periods of increased market volatility. For example, you can buy the VIX Index or options to take advantage of the anticipated increase in volatility or to hedge your long positions.

You can use the volatility indicators on our platform to help identify when market volatility may be set to increase. These include Bollinger Bands, the Average True Range Indicator, the VIX, the Keitner Channel Indicator, the Donchian Channel Indicator, the Chaikin Volatility Indicator, the Twiggs Volatility Indicator and the Relative Volatility Index.

It's important to have an appropriate emergency fund equal to about three to six months of living expenses so you will not be forced to sell investments in times of market weakness.

How to trade on market volatility

1. Create an account or log in
2. Choose the market and select 'buy' to go long or 'sell' to go short
3. Set your position size and manage your risk
4. Open and monitor your position

CFDs – short for 'contract for difference' – are leveraged derivatives. Trading with financial derivatives means that you don't own the underlying asset, but you're taking a position on its price movement. You can trade market volatility on markets such as shares, commodities, forex, and cryptocurrencies.

You can trade CFDs on the spot market, which is suitable for shorter term trading as the spot price is the immediate real-time price of the asset.

You can also trade CFD futures, which allow you to take a position based on your prediction of what the price of an underlying asset will be at a future date.

You can also trade options on your CFD account to take advantage of an anticipate change in volatility or a sharp price move in the underlying asset. All options are cash settled – meaning that they cannot result in the physical delivery of the underlying security.

With CFDs, your currency exposure and initial margin will vary according to the contract of the ETF chosen. Your wins or losses will depend on the outcome of your prediction. To manage risk when trading CFDs, you can set stop loss orders to prevent outsized losses.

Remember, trading with CFDs comes with added complexity and risk attached to leverage. Your position will be opened at a fraction of the value of the total position size – but you can gain or lose money much faster than you might expect. Your losses can even exceed the initial margin paid because potential profits and possible losses are magnified to the full value of the trade. It's useful to keep in mind that past performance isn't a guarantee of future patterns

Stock market volatility summed up

• Stock market volatility refers to the frequency and size of a market move in an upward or downward direction over a specified period
• A higher VIX reading or implied volatility indicates increased fear and uncertainty in the market
• Volatility is an intrinsic feature of financial markets, and periods of higher volatility should be expected
• You can use breakout strategies and scalping to make profitable trades at times of increased market volatility

¹ Corporate Finance Institute, 2023