We need to look at the volatility of any investment and understand what factors influence it. When investing in the stock market or other financial instruments, the volatility must be calculated and predicted. How to predict market volatility?
The more volatile a market is, the riskier it will be to invest in it and the less predictable. Some strategies work well in volatile markets, while others are useless.
There are a lot of factors that affect an instrument’s volatility. In this article, we’ll look at the most important ones.
Even when you buy a real asset like a house, you should evaluate how volatile the investment is.
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Liquidity affects volatility
The biggest thing that affects a financial instrument’s volatility is its liquidity. The general rule is that the more liquid an asset, the less volatile it is.
There will be times when some very liquid instruments become highly volatile. But most of the time, very liquid stocks tend to be more stable and move slower. We’ll look at other factors that can cause violent movements later.
When an instrument is liquid, big investors buy and sell, so supply and demand are balanced. Stocks such as bluechip stocks have a lot of trading throughout the day.
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Blue-chip stocks have a very high capitalization compared to so-called small-cap stocks. Banks, hedge funds, brokers, and big traders will be interested in buying and selling blue chips every day.
A heavily capitalized stock is more liquid and less volatile. Apple or Microsoft are examples of large capitalized stocks, and you can find these in thousands of other financial products like ETFs or investment funds.
Liquidity affects the spread between the bid and ask
A large blue-chip sell order from a broker will undoubtedly find a counterparty and not cause the price to move quickly.
Let’s take a simple example. A trader placed a large sell order at $ 100, but the stock was barely traded, and there were only a few buy orders at $ 90.
A large spread between the bid and ask has just been created in the stock book. If the trader needs to sell, he’ll have to lower the selling price to $ 90, where the few interested buyers are. In this way, the share will rapidly drop by $10 in a few seconds, losing 10% of its value.
This is an example of pure fantasy, but it serves to understand why low liquidity makes prices move quickly.
By analyzing the stock’s book, you can predict the volatility. When a stock has a lot of big orders at different price levels, it usually trades slowly. The market will absorb each order; it will be liquid and stable.
Some news can create a lot of volatility.
Since liquidity and capitalization are the most important factors, other elements influence volatility.
Every day there are news and analyses about the stock market or a particular company. Some of this news has no impact; it serves only to entertain the public. But some of them are real market movers.
Global news that influences volatility
Some news can make a national or even global stock market move massively. A natural disaster, a diplomatic incident that can lead to a world war, a pandemic are just a few examples.
The more sudden and unexpected the news is, the more violently the stock market will react and the greater the volatility. In finance, the terrible news is called “black swan”.
Some black swans are sudden, like the earthquake and tsunami in Japan in 2011. Other news is more predictable, as the generalized lockdowns in the covid emergency. Bad news creates more volatility as markets tend to drop very quickly and then rise slowly.
After the news, the stock market will try to settle down and absorb the loss or continue in its direction. The tsunami in Japan will have a different impact than Covid. The more unpredictable the effects of an event are, the longer the period of high volatility.
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Say there’s a natural disaster, and we can figure out how it’ll affect the economy and the stock market. Stock prices will fall, and they’ll keep falling until they get to a point where the price will balance out and settle down.
If an event has multiple implications and no one can predict what will happen, it’ll be a different story. We will see rapid declines and then equally rapid rises over long periods. Each new piece of information will lead the market to rise or fall, creating uncertainty and, therefore, volatility.
Central banks’ monetary policies and volatility
News that could increase volatility relates to the choices on monetary policies by large central banks such as the Fed or the ECB.
Analysts usually do their homework before announcing anything, so it’s rare to see any real surprises. But sometimes, the market can get nervous about specific things. Investment banks often use these movements to take advantage of large sell and buy orders, artificially creating volatility.
Earnings and volatility
American stocks report earnings every quarter, and the news is highly anticipated. Again, earnings are preceded by hundreds of financial analyst forecasts and analyses. The rule is that the more earnings deviate from analysts’ forecasts, the more volatility is likely to be created.
Some stocks always react nervously to their earnings, so we can easily predict their volatility and trade with options. In addition to earnings, any news can come out on equities and increase volatility.
Again, the more surprising the news, the more volatility it will create. Furthermore, the smaller the share, the more its price will be influenced by news.