How Wall Street Measures Stock Volatility
Stock market volatility is one factor to consider when building a diversified, risk-tolerant investment portfolio. But what does "stock volatility" actually mean, and how is it measured?
Here, we share what stock volatility is, how it's measured, and how that information can help you when choosing investments.
What is Stock Volatility?
Before we dive into how Wall Street measures stock volatility, let's define what we mean by stock volatility.
Volatility refers to the degree of variation in a trading price series over time.1 A highly volatile stock experiences larger price swings, both up and down, while a low-volatility stock has smaller, more predictable price movements.
Volatility is often seen as a measure of risk. Higher volatility may imply greater uncertainty and risk, as prices can change rapidly and dramatically. On the other hand, lower volatility may suggest a more stable and predictable stock, which may be less risky but also potentially less rewarding.
Measuring Stock Volatility Using Standard Deviation
One of the most common methods used on Wall Street to measure stock volatility is standard deviation.1 This statistical measure quantifies the amount of variation or dispersion in a set of values. In the context of stocks, it helps us understand how much the stock's price deviates from its average price.
The equation for standard deviation is Volatility = Standard Deviation over the square root of the Time Period (Volatility = σ√T where σ = standard deviation of returns and T = number of periods in the time horizon).
Here's how it works:
- First, gather a set of historical prices for the stock.
- Calculate the average price over the chosen period.
- Then, calculate the differences between each price and the average.
- Square each of these differences to eliminate negative values.
- Average these squared differences.
- Finally, take the square root of this average to get the standard deviation.
The result measures how much the stock price typically varies from its average. A higher standard deviation means higher volatility, while a lower standard deviation indicates lower volatility.
Beta: A Measure of Systematic Risk
Another important measure of stock volatility used on Wall Street is beta. Beta measures the sensitivity of a stock's price movement relative to a benchmark index, often the overall market index like the S&P 500.2 It helps investors understand how volatile a stock is compared to the market as a whole.
- A beta of 1 means the stock tends to align with the market.
- A beta greater than 1 indicates the stock is more volatile than the market.
- A beta less than 1 suggests the stock is less volatile than the market.
For example, a stock with a beta of 1.5 may move 50% more than the market in the same direction, whether up or down. On the other hand, a stock with a beta of 0.5 would move half as much as the market.
Implied Volatility from Options
Options, which are financial derivatives, also provide a window into stock volatility through implied volatility.3 Implied volatility is the market's expectation of how much a stock will move in the future and is derived from options prices.
High implied volatility indicates the market expects significant price movement, while low implied volatility suggests the market expects little price movement.
Various factors influence options prices, including the stock price, time until expiration, interest rates, and market expectations.4 By looking at the prices of options with different strike prices and expiration dates, investors can infer the market's view on future volatility.
Stock volatility is multifaceted, and Wall Street employs various methods to measure and understand it. Whether it's the standard deviation for historical price movements, beta for comparison to the market, or implied volatility from options, these metrics offer valuable insights for investors
This content is developed from sources believed to be providing accurate information, and provided by Twenty Over Ten. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.
