What is volatility? What is volatility and why is it needed?

2024 Author: Howard Calhoun | [email protected]. Last modified: 2023-12-17 10:16

What is volatility? This term refers to the volatility of prices. If you determine the minimum and maximum prices for a certain period on the chart, then the distance between these values will be the range of variability. This is what volatility is. If the price increases or decreases sharply, then the volatility will be high. If the range of changes fluctuates within narrow limits, then it will be low.

Origin of the term

The term "volatility" comes from "volatile" - a Middle French word, which, in turn, appeared from the Latin "volatilis" - "fast", "flying". It is worth noting that in French there is another definition of volatility. The term is also used to refer to overpricing.

Volatility theory

This theory is based on the analysis of changes in any economic indicators: interest rates, prices, and so on. This takes into account the changes that occur duringlong time. When defining what volatility is, econometricians distinguish two main components. The first is a trend, when prices fluctuate according to a certain pattern. The second is volatility, when changes are random. In order to accurately predict the situation, it is necessary to take into account not only the average value, but also the expected deviations from the average level.

For example, when analyzing the securities market, it is necessary to take into account random deviations of indicators, since the cost of options, shares and other financial instruments is highly dependent on risks. The theory of volatility was developed by the American economist Robert Engle. He determined that deviations from the trend can change significantly over time - periods of minor changes are replaced by periods of strong ones. The real volatility of the exchange rate is changeable; for a long time, economists used only static methods in their analysis, based on the constancy of this indicator. Robert Engle in 1982 developed a variable spread volatility model that made it possible to predict price changes.

Types of volatility

Considering what volatility is, it is necessary to note two types of it: historical value and expected value. The historical view is an indicator equal to the standard deviation of the prices of a financial instrument for a specified period of time, which is calculated based on the available information about its value. If we talk about the expected volatility of the market, then this indicator is calculated based onthe value of a financial instrument, taking into account the assumption that the market price reflects possible risks.

The market should take into account not only the direction of movement, but also the period for which changes occur, since this determines the likelihood that the price of assets will exceed the values that are critical for the participant. To establish an indicator of the price volatility of the market as a whole, it is necessary to calculate the stock volatility index.

How and why volatility is measured

The easiest way to determine this indicator is the standard deviation indicators and the use of the true price range - ATR. First of all, you need to determine the average volatility for your currency pair over a long time period, and then in the analysis process you need to note the ratio of the current and average volatility.

To establish what price volatility is, it is necessary to analyze the potential profitability of a currency pair. When the price change indicator is at a high level, and the spread is insignificant, then we can talk about high profitability. It is worth noting that a high level of volatility is associated with high risks, since a protective stop loss order will be significant, and possible losses will also increase.

Bollinger Bands

To clearly see what volatility is, you need to use an informative indicator - Bollinger Bands. It draws a channel for prices, which expands significantly with a sharp jump in changes. If the breakout is in a narrow range, then this may indicate the beginning of a profitable movement, but it is worth remembering that quite often such breakouts can be false. When we determine the average value of the volatility of currency pairs per day, then we can subtract this indicator from the formed daily minimum or maximum and, as a result, get the goals of taking profitability and placing a stop loss order.

Let's assume that if we take into account that the pair usually moves within a hundred points per day, then there is no need to put a "stop loss" at a distance of two hundred and it makes no sense to count on a large profit that exceeds the average daily range. If we analyze price risk in financial markets, then, for example, the calculation of the volatility of shares should take into account not the sequence of prices itself, but the sequence of relative changes. In this way, it will be possible to achieve greater comparability of different assets. For example, new shares can increase and decrease in value dozens of times, so it is impossible to calculate the volatility of these shares using absolute values. In addition, the sequence of relative changes is more stable, in the sense that its variance and mean are stationary when compared with the same indicators of unanalyzed prices. At least that's how it's supposed to be.

Volatility indicators

Despite the fact that many employees of dealing centers claim that the volatility of currency pairs indicates a good profitability of the transaction, do not forget that a high levelvolatility is an increased risk. On a volatile pair, luck can quickly turn away, and losses will increase significantly. To reduce risk, you should always use a stop loss order, even if the market is moving in the direction of profit and says nothing about possible losses. In the Forex market, volatility indicators include Bollinger Bands, CCI, and Chaikin indicators. Standard deviation indicators are also used as indicators.