What is the best way to measure share price volatility?

Is volatility good or bad when trading stocks?

You’d never make a profit from going long or short on a stock if its share price never moved. The fact that prices are always fluid in the financial markets creates daily and even hourly opportunities for retail traders. High volatility means that the degree of the price movement has the potential to be sharper than normal. This makes higher-than-average profits possible but may also generate higher-than-average losses.

It takes discipline for retail traders to take full advantage of volatility. Adopting risk management techniques to preserve your capital and take smaller profits to build longer-term positions is essential to ride out periods of uncertainty. It’s also okay for retail traders to sit on their hands during periods of significant volatility. If you don’t know where or why a price is moving in a certain direction, sometimes the best move to make is none at all.

The most common measures of stock market volatility revealed

Four primary measures of volatility are used to gauge the degree of risk and potential loss when buying and selling any publicly listed equity. 

Standard deviation

The number-one metric to determine the volatility of a stock is standard deviation. This is known as a quantitative calculation. To break down the jargon, when the standard deviation figure is high, you can expect a wider range of potential returns on investment in a stock. If the standard deviation figure is lower than anticipated, this suggests you can calculate expected returns with more certainty, as its market price has a narrower trading range. 

The formula often used to assume the standard deviation of an equity is the square root of the asset’s variance. You must first determine the average squared deviation from an asset’s average price and then work backwards to calculate the square root of this figure. 

One of the biggest criticisms of standard deviation as a measure of volatility in the stock market is that it’s based on historical data and is not forward-looking by nature. In any case, exclusively using standard deviation and historical data to form a basis for potential returns in the future is never a sensible move. That’s because there is no guarantee of the past being replicated. 

The other drawback of standard deviation is that it doesn’t separate the difference between upward and downward price movement. For example, if an equity posts substantial growth in its share price in a 12-month period, the standard deviation reading would be high. This could mislead novice investors into thinking the asset is volatile and cause them to overlook the bullish sentiment surrounding it. 

Maximum drawdown

The concept of maximum drawdown is a general indicator of an equity’s downside risk during a set timeframe. Some investors decide to use maximum drawdown as a measure of volatility in its own right, or combine it with other metrics like Calmar Ratio and Return over Maximum Drawdown. 

There is a simple formula to determine the maximum drawdown value of a share price. Subtract the peak value from the trough - or bottom - value and divide the answer by the peak value. 

For argument’s sake, let’s say the trough value was $5 and the peak value was $10. You would take the following calculation: 

5 - 10 / 10 = -50% 

The larger the maximum drawdown percentage, the more an equity is considered to be volatile. The worst possible maximum drawdown is -100%. In this case, the investment becomes entirely worthless and all capital committed is lost. 

Risk-averse investors will prefer equities that have tighter maximum drawdowns, as this is an indicator that general losses from any such investment will be only a small percentage of overall capital. 

One of the biggest drawbacks of maximum drawdown is that although it accounts for the biggest potential loss before a new peak is achieved, it doesn’t factor in the regularity of losses or the size of any profits. 

Beta 

After standard deviation, beta is generally the second most popular metric for stock volatility. Beta helps to determine the broad risk profile of an asset. Investors typically use beta to gauge risk for equities housed within a leading index fund such as the S&P 500. 

When it comes to measuring beta, the neutral benchmark is set at 1.0. Usually, the index itself will be given the neutral benchmark, with equities listed within the fund likely to set either side of this figure. 

The higher the beta score, the more volatile an equity’s market value is likely to be. If an equity has a beta score of less than 1.0, this means it has a much tighter trading range. That could suit risk-averse investors or those who prefer short, sharp trades called ‘scalps’ where traders open and close orders on an asset within a matter of minutes or seconds to take advantage of price fluctuations. 

The concept of beta was born out of the original capital asset pricing model (CAPM), which calculates the value of equity funding and the apparent risk to potential investors. It has a basic formula of covariance divided by variance. The downside to beta as a rule of thumb is that it fails to factor in the of an asset. 

The CBOE Volatility Index (VIX) 

The VIX is one of the most influential metrics to determine the expectation of volatility in indices options for the S&P 500. Experienced equities traders have described VIX as the ‘fear index’, as it measures the uncertainty in the markets. The VIX was the brainchild of the Chicago Board Options Exchange (CBOE). It is a forward-looking measurement, determining the likely movement of share prices in the next 30 days of trading. It’s underpinned by put and call options on the S&P 500 index. 

If the VIX is high in historical terms, it suggests the stock markets are more likely to be volatile and bearish. In the year to date, with inflation ramping up globally, VIX has risen 76%. That is a considerable increase. Around the time of the global financial crisis in 2008, VIX soared to an all-time high of 79.13, compared with 29.43 on October 21, 2022. 

The general barometer of VIX is that anything over 30 equates to credible uncertainty across the financial markets. 

How to minimise the impact of volatility on your equities portfolio 

One of the number-one options you have to curb the impact of volatility on the equities in your portfolio is to diversify the asset classes you invest in. Government bonds and stocks tend to work in opposite directions and can be an effective hedge against falling equities. 

You may also consider rebalancing your overall portfolio based on a new risk-reward profile. In particularly bearish market conditions, it may be a good idea to reduce the percentage of stock holdings within your portfolio. A balanced asset allocation model is often the way to go. You can include some high-risk stocks with the potential to yield huge payoffs, as well as more conservative government or commercial bonds. 

The inflationary climate will also influence your choice of bonds. In times of high inflation, it’s possible that low-risk, low-return bonds do not even keep pace with inflation, thereby eating into your portfolio’s purchasing power. 

Ultimately, volatility is one of the realities of investing that simply cannot be avoided in its entirety. But by hedging or diversifying your portfolio, you can lessen the risk to your overall funds until economic conditions become more bullish. 

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