What is volatility?
In finance, volatility is a measure of the amount of variation in prices over time, and it is used to quantify the risk of an investment. Higher volatility means more risk is associated with the investment, as prices can change rapidly and unpredictably.
The different types of volatility
There are three types of volatility: historical, implied, and future realized.
- Historical volatility is the actual variation in prices in the past. This can be measured by looking at price data over a specific period.
- Implied volatility is what investors expect future volatility to be. It is calculated by looking at the underlying asset’s value and the options prices.
- Future realized volatility is the actual variation in prices that will occur in the future. It is calculated by using historical data and predicting how it will change in the future.
Steps to calculate volatility
There are three steps to calculating volatility:
- First, you need to calculate the standard deviation. This is a measure of how much the prices have varied from the average price.
- Second, you need to find the variance. This is calculated by taking the squared difference between each price and the average price.
- Third, you need to multiply the standard deviation by the square root of time. This will give you the annualized volatility.
How to reduce volatility in your portfolio
- There are a few things you can do to reduce the risk of volatility in your portfolio:
- Diversify your investments. Diversifying your investments means that you spread your money across different investment vehicles, which will help reduce the risk if one investment performs poorly.
- Hedge your investments. Hedging your investments means that you take out insurance against potential losses. This can be done by buying put options or selling call options.
- Use stop losses. Using stop losses is a way to limit your losses if the price of an investment starts to drop rapidly. A stop loss is set at a specific price point, and when the stock reaches that price, it will automatically sell. This will prevent you from losing more money than you intended on a particular investment.
There are a few investments that have low volatility:
- Precious metals like gold and silver are a good option for investors who want to hedge their portfolios against volatility. These metals are less volatile than other investment options, and they tend to hold their value over time.
- Investing in bonds is another way to reduce the risk of volatility in your portfolio. Bonds are issued by governments or companies and represent a loan repaid at a fixed interest rate. The repayment schedule is usually spread out over many years, making them a low-risk investment option.
- Real estate is another option that has low volatility. The value of real estate usually doesn’t change as rapidly as the stock market, and it can be an excellent way to diversify your investment portfolio.
There are a few investments that have high volatility:
- Cryptocurrencies are a high-volatility investment option. Price predictions are hard to make, and the value of these currencies can change rapidly. The space is still young and growing, which leads to large price swings.
- Penny stocks are a high-risk, high-volatility investment option. They are stocks traded for less than $5 per share and can be a great investment opportunity, but they also come with many risks. Because penny stocks are not as heavily regulated as other stocks, there is the potential for fraud and manipulation. For this reason, it is essential to do your research before investing in penny stocks.
- Oil is a high-volatility investment option. It is susceptible to political and economic factors, which can cause its price to swing wildly.
Volatility case study
Let’s look at an example to see how volatility can impact your investments. Assume that you invest $1,000 in a stock with high annualized volatility. In one year, the stock price could be as high as $1,500 or as low as $500. If the annualized volatility was at a lower rate, the stock price could be as high as $1,300 or as low as $700. As you can see, the higher the volatility, the greater the potential gain or loss on your investment.
The bottom line
Volatility is a measure of how much the prices of an investment can change. High volatility means a greater risk of losing money on your investment, while low volatility means that the prices are more stable. You can do a few things to reduce the risk of volatility in your portfolio, including diversifying your investments, hedging your investments, and using stop losses. Volatility can also impact your overall gain or loss on an investment. Low-volatility investments include real estate, precious metals, and bonds.