What Is Volatility?
Volatility refers to the movement in the price of assets over time. These assets often have multiple upward and downward movements in their price in a given period compared with other assets. The more the price of an asset changes positively or negatively with time, the higher the volatility of that asset. Volatile assets are also risky, and an asset whose price moves upwards and downwards multiple times in a row over a short period has higher risks for investors than an asset with a fairly stable price.
Although the stocks of some small companies are also volatile, cryptocurrencies are perfect examples of volatile assets. The best way to have a feel of volatility is to keep refreshing the price or market cap of Bitcoin on exchanges or data aggregator websites.
- Volatility is the upward or downward movement of the price of an asset with time.
- The more volatile an asset, the higher the risk involved in holding that asset.
- Cryptocurrencies are volatile because the price movement upwards or downwards within a given time is higher than most asset classes.
- The average price of assets taken over a period usually forms a normally distributed bell curve.
- The higher the standard deviation, the less volatile an asset is over the period under consideration.
- Variance and standard deviation show movement from the average price of an asset over a period, and they can be used for risk measurement.
- Variance and standard deviation are not the best-tested methods for making investment decisions.
The standard for measuring the performance of most assets always includes the calculation of volatility. Standard deviation from the mean and variance—the root of deviation—are mathematically sophisticated methods for measuring volatility. They are, however, not the best-tested methods for making investment decisions. In this context, the volatility is measured using the spread of a bell curve in the case of standard deviation. The price of an asset usually follows the bell curve or the curve of a normal distribution, which you can find by calculating the mean of a specific range. In a normal market situation, the higher the standard deviation, the less volatile the asset’s price will be. The spread is visible in corresponding curves for the distribution.
Suppose a trader or investor buys one Bitcoin at $38,000 and sells one Bitcoin for $40,000 in the space of 30 minutes. The percentage change in 30 minutes was 5.26%, indicating a volatile asset. In normal market situations, such movements are continuous unless there are factors other than the price motivating holders of the asset. Even then, the rush of bulls into the market due to the fear of missing out (FOMO) can cause unreasonable spikes in the price of these assets.
The opposite situation happens when market participants anticipate a negative event. In that case, billions will disappear from the market in seconds. Such cases are common in the cryptocurrency market. A 50% fall in the price of a cryptocurrency in 10 minutes means that holders have lost 50% of their funds.
Dividing the sum of the price changes by the number of price changes gives the mean, which can then be subtracted from each price point and squared to get the variance. The standard deviation is the square root of the variance.
The simplest possible way to calculate the volatility of an asset is to look at the percentage change in price in the period under consideration. The formula for that is given by:
(New Price - Old Price) / Old Price x 100
In our example case of Bitcoin moving from $38,000 to $40,000, the solution for percentage change in price becomes:
($40,000 - $38,000) / $38,000 x100 = $2,000/ $38,000 = 0.05263 x100 = 5.263%
The other way of calculating volatility is the preferred method used in the stock market by professional traders. It is called the average true range (ATR). The ATR measures the asset’s highest and lowest trading price in the period under consideration. It is written mathematically as:
Current high - current low Current low - previous close Current high - previous close
So in our example case of Bitcoin at $38,000, the ATR is the maximum of all current highs minus current lows divided by the number of periods which gives us:
Max(CH - CL) / 1 = 2,000
You can already see the high ATR of 2,000, which shows that the asset is highly volatile. The calculations here may not be as clear as representing each period in excel and calculating the average of all the true ranges.
Differences Between Implied Volatility and Historical Volatility
Implied volatility is a forward-looking measure of volatility that is calculated by taking the standard of the current returns of the asset in question when the price has not changed in some dramatic way. It is different from historical volatility in that it calculates volatility based on past returns on the asset under consideration. They are both volatility measures and are most common in the options market. The mathematical equations for arriving at solutions such as Black-Scholes are outside the scope of this article.
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