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Understanding Volatility: What is It, What Causes It, and How to Play It

A smooth sea never made a skilled sailor. Trading volatility means risk, but also means opportunity. If you looking to navigate through difficult volatile markets, here’s a quick guide to help:

What is Market Volatility?

Market volatility, to put it in simple terms, is basically the standard deviation we often find in statistics, and as it is known, the higher the standard deviation (fluctuations), the higher the risk will be.

How exactly does volatility affect the market? Risk and unpredictability go hand in hand with volatility, but so does inevitability as the markets are bound to move up and down constantly.

In volatile times, some may say that more cautious approach is needed as the market becomes very unpredictable and will experience large fluctuations in value and heavy trading.

On the other hand, however, without volatility investors simply would not have what are amazing opportunities to buy low and sell high.

There are a wide range of factors that cause volatility. The most basic is simply uncertainty. Uncertainty can be fueled by basically three key factors:

  1. Political and Economic Factors:

Governments are in charge of regulating industries and their policies’ impact can have a whiplash effect throughout the whole economy.

Reactions on stock prices can be felt due to Government action, ranging from things like the way they oversee industries to the means they employ to do so.

Elections and even speeches can influence the perception investors have on the economic outlook of a sector or country.

Economic data also plays a key role as a strong economy correlates to positive reactions and expectations from investors.

  1. Industry and Sector Factors

Certain specific events may increase volatility within a particular industry and sector.

Likewise, Macroeconomic Indicators and other Bureau of Labor Statistics (BLS) releases (Jobs data, Consumer Price Index, NonFarm Payrolls) are certain to impact the performance of the market.

Economists (and investors alike) use all the aforementioned items’ data to assess the current state of the economy as well as to forecast what the future levels of economic activity will be.

This data is highly anticipated as these forecasts allow investors to look into several sectors of the economy and understand which ones are expanding and which ones are contracting.

If an indicator falls short of expectations, markets may increasingly become more volatile.

  1. Company Performance

Volatility may simply be seen on a specific company but, if that company has a significant market quota, it can affect the broader market.

So, can we actually predict Volatility?

The short answer is no. But we can certainly prepare for it. If the market was predictable like that, volatility would simply cease to exist.

We can, however, keep an eye out using two different indicators:

  1. When it comes to historical volatility, it can easily be found by calculating the average deviation of the instrument from its average price.
  2. If you are looking into a read on implied volatility, look no further than the VIX (also known as the “Fear Index”).

It was created Chicago Board Options Exchange (CBOE) and the rule is simple: the greater the reading, the greater the risk.

How can play the Volatility Game then?

It is imperative to understand that investors like volatility as it provides with amazing opportunities to invest simply on account of businesses becoming undervalued.

As such, in volatile times, you will certainly find companies to be priced below their true value, or, to put it simple, a “fire sale”.

By doing research into companies that are certain to rebound (no debt, solid management, proven track record, etc.), you are almost granted to see your portfolio grow.

Wrapping up

As Carl von Clausewitz, Prussian general and military theorist, once said:

“Although our intellect always longs for clarity and certainty, our nature often finds uncertainty fascinating.”

With that thought in mind, we encourage you to look forward to volatility, to welcome it into your investment strategy and, especially, to profit from it.

   

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