The Value of Volatility

Holborn Blog Article

What is Volatility?

Categories

analysis

The global stock markets have followed the cryptocurrencies into waves of volatility:

On Tuesday 6th February, the US Dow Jones was down 500 points – then up by 350 – then flat. Phew!

“Bitcoin initially dropped below $8,000 on Friday [2nd February] during a wild day of trading that saw the cryptocurrency drop by as much as 15%, to a low of $7,700, before jumping and eventually ending the day in positive territory, close to $9,000.” (Ukbusinessinsider.com)

VIX, the globally-recognised index of volatility, has registered triple digit surges in the week commencing 6th February to hit a 3-year high; “the VIX surged by 115.6 percent on Monday to 37.32. It rose briefly early Tuesday to over 50, the highest level since Aug 2015. The VIX then dropped to 22.42, rose to over 45, before fading to roughly 35.” (qz.com)

Whether stocks are shot and Bitcoin is bit the dust for good remains to be seen – but what is the role of volatility in all of this?

 

What is Volatility?

Volatility refers to how much uncertainty there is over the value of an asset. Practically, volatility means that the price of an asset moves very fast in either direction. Mathematically, volatility is derived from the standard deviation between returns from an asset. A good way to understand volatility is to understand that “commonly, the higher the volatility, the riskier the security.” (Investopaedia.com)

 

How is Volatility measured?

Global Volatility is measured by the CBOE Volatility Index – otherwise known as VIX. VIX is based on S&P 500 stock index option prices.

Although VIX is based on a US stock market, it is recognised as an index of global volatility. Why? Two reasons: firstly, because global uncertainty is always priced into the US stock market and secondly, because the US stock market is so central to the global economic system.

What does Volatility mean for the markets?

Volatility shows for certain that the market is uncertain – and that the market is even scared if volatility is very high; VIX is often referred to as the market’s “fear gauge”.

Price crashes are characterised by high volatility as they happen. And crashes are often too preceded by years of particularly low price volatility – which can then be used to predict the coming crash; two years before the Asian Financial Crisis in 1997 the VIX hit a historic low and the same happened in 2006 immediately before the Credit Crisis.

And guess what? 2017 saw an all-time low in the VIX, with it bottoming out at 9.14 in November, having fallen by more than 17% over all of 2017. So does that mean trouble is coming? CNBC observe that, “some investors have interpreted this as a sign of current market risk and that there could be a sudden correction in stock markets, meaning many people could be about to lose vast sums of money.” Maybe 2018 really is the year of the bear?

“Volatility is lower than average historical levels,” noted Aaron Brown of Bloomberg.com back in July 2017, “but it’s at levels typical of the bottom of a quiet period between two crises … Every five years or so volatility rises above 20 percent for a year or two, sometimes getting much higher but usually not, and in between it sweeps out a shallow bowl-like trading pattern that bottoms at about 10 percent.”

Are we then on the verge of such a crisis? Well it seems to have already happened in the world of cryptos, which are already in a whole other league when it comes to high volatility.

The huge volatility involved in the crypto sell-off since Christmas has certainly lead recently to practical problems for private investors, with online crypto exchanges becoming overwhelmed with traffic and new transactions being frozen out along with existing transactions being delayed for days. Alex Herbert, Senior Partner at Holborn says: “Be aware that trading service provision is in its infancy out on the web, with some systems still going into paralysis at key times; don’t over-expose yourself, and read the small print, especially charges.”

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