What causes market volatility?


TL;DR

  • Market volatility is a measure of the variance of returns on a market index over a given period.
  • High volatility is associated with high risk and unpredictability.
  • Historical market volatility represents the current market volatility based on historical returns. Implied market volatility represents the future market volatility based on options in the market.
  • A market is considered volatile if it rises or falls more than 1% over a given period.
  • The most common market volatility index is the CBOE VIX, which is based on S&P 500 index options and provides a 30-day forward-look at market volatility.

What is market volatility?

Volatility is normally characterized by rapid change and unpredictability and this definition stands true in the world of investing. In technical terms, market volatility is a statistical measure of the variance between possible returns for a given market index. In other words, market volatility is the measure of the changes in value that a market experiences over a certain period. If a market is considered highly volatile, it is often very unpredictable and experiences large fluctuations in value. Due to the unpredictability, a highly volatile market is associated with high risk and should be approached cautiously. Stereotypically, high market volatility often aligns with economic hardship, while low market volatility often aligns with economic growth.

What causes market volatility?

Often, market volatility is caused by economic factors, economic news, interest rate changes, and fiscal policy are a few topics that seem to consistently affect the volatility of the market. More recently, a leading factor has been political developments. Volatility is a reflection of investor sentiment, therefore any factor that can influence investor behavior will affect market volatility. Generally, a market won’t be considered volatile unless it rises or falls more than 1% over a sustained amount of time.

How is market volatility measured?

As mentioned, volatility is a measure of the variance of returns on an asset or market index over a given period. Volatility calculations can be historical (historical volatility) or forward-looking (implied volatility). Historical market volatility is often represented by a statistical measurement known as the standard deviation. The standard deviation is a measure of how spread out returns are from the average return or mean. Therefore, a highly volatile market will have a high standard deviation due to the large swings in returns it experiences over time. Implied market volatility is inferred using option prices in the market. An option is an agreement to either sell or buy an underlying security at a preset price before a certain expiration date. The price of an option is dependent on the perceived probability of that stock moving in a certain direction. Therefore, volatility is a major component of calculating various option prices. When looking at implied market volatility, many turn to a volatility index, which uses index options to infer forward-looking market volatility.

Market volatility index

The most common market volatility index is the CBOE VIX or Chicago Board Options Exchange Volatility Index. The index is based on the S&P 500 index options and provides a 30-day forward-look at market volatility. Since the market volatility index represents the projected volatility, it also represents market risk and investor sentiment. Because of this, some refer to the index as the “Fear Index” or “Fear Gauge.” During a market crash, it is common to see the VIX move up in value, as this represents high volatility and high investor fear. When the market is growing, it is common to see the CBOE index and associated volatility decrease.

Bottom line

Market volatility is a great indicator of the state of the market and overall investor sentiment. Characteristically,  a highly volatile market experiences large swings in value, while a less volatile market experiences steadier returns. Volatile markets can be caused by a variety of outside factors including macroeconomic news and political change. Regardless of the cause, volatile markets represent unpredictability and uncertain investor sentiment. Many investors turn to a market volatility index to get a gauge for overall market risk. A common market volatility index is the CBOE volatility index, which uses the S&P 500 index options to predict future volatility. At the end of the day, volatility is a great measure of market risk, and keeping a pulse on market volatility is essential when deciding how to manage an investment portfolio.

Courtney is a freelance writer and finance professional based out of New York City. You can connect with her on Twitter at @CourtSaintJames.

The above content is provided is paid for by Public and is for general informational purposes only. It is not intended to constitute investment advice or any other kind of professional advice and should not be relied upon as such. Before taking action based on any such information, we encourage you to consult with the appropriate professionals. We do not endorse any third parties referenced within the article. Market and economic views are subject to change without notice and may be untimely when presented here. Do not infer or assume that any securities, sectors or markets described in this article were or will be profitable. Past performance is no guarantee of future results. There is a possibility of loss. Historical or hypothetical performance results are presented for illustrative purposes only.

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