Volatility is one of the most misunderstood factors that determine a good investment opportunity. That is unfortunate, because it is also the single most important one. When people think of high volatility markets they think of high risk, dangerous markets that should be avoided. However, volatility in itself is not what determines risk. It is simply a feature that describes a market. For example, speed is an element of travel. You can travel slowly or quickly. Travelling at 200 mph in a motorbike is considered, for good reason, dangerous. However, travelling at 500 mph in an airplane is widely accepted as the safest form of transport. Speed is like volatility. You can be travelling at 10 mph on the back of a horse and be in more danger than travelling a hundred times faster on the back of jet engine. Higher speed can imply danger and higher risk, but not necessarily. Walking, for instance, might be a safe mode of transport, but if you are walking through the bad part of town you want to be moving faster, and safer, in the back of a speeding car.
Volatility is nothing more than a way of measuring the amount by which an asset is expected to change in any given period of time. If you expect the stocks of Apple to rise quickly in the weeks after the sale of their new Ipod you would say they have a high level of volatility. It simply describes the speed something changes, or is expected to change, in the market. Change can be good for business. If prices of things never changed, or there was a low volatility, there would not be much of a margin for traders and merchants to sell products at a profit.
There are two main types of volatility, historical and implied. Historical volatility is the actual or statistical rate of change an asset has displayed through time. It is calculated by using the standard deviation of an assets price from its price in any given number of days. And you probably thought standard deviation was a useless thing to learn at school, right?
Knowing the volatility of the market you are investing in, is very important when choosing which strategy you are to use. Strategies that work in high volatility markets do not work in their low volatility counterparts.
Implied volatility is very different. It is not based on actual price change but on the current market price compared to an option pricing model. For instance, if the premium of an option increases without the value of the asset changing, its volatility will have increased. This kind of volatility is often a reflection of overpricing or undervaluing of an asset. For example, when the dot. com bubble started, companies without much in the shape of assets, clients, or services to offer, had stocks that did not reflect the real value of the company. This was a case of a high volatility due to serious overpricing.
The beauty of trading is that if done smartly you can make a profit out of applying the right strategies no matter how volatile the market is or in which direction it is going.
