As intimidating as a highly volatile market can be, volatility might present opportunities.
If you think an all-night rave sounds exhausting, consider the dancing plague of 1518.
During the era of the Holy Roman Empire, a woman inexplicably began to dance erratically in Strasbourg, a town located in modern-day France. Eventually, her bizarre behavior infected several dozen other people, who joined her frenzied dancing in the street.
The more the dancing spread, the more concerned that made everyone else. Eventually, the boogie fever continued for so long that the local medical, government, and religious officials intervened, sending them for medical treatment and, in some cases, exorcism.
Historians don’t know why the dancing plague infected so many dancers. However, some speculate stress-induced psychosis, superstition, or the fear of missing out might have compelled them to join in the impromptu dance party.
While we may not know the real reason these people cut a rug, we do understand how others reacted to it. As more people participated in the strange phenomenon, those who weren’t dancing began to panic — which, according to some historians, could possibly have contributed to the duration and the intensity of the dancing.
As strange as this story seems, we can see elements of this behavior in the stock market today. Sometimes, people may cause an unpredictable move in the stock market — such as when mass selling or bandwagon buying occurs— that could cause volatility. Much like the confusing nature of a dance plague, volatility can sometimes compel investors to panic because they don’t understand it.
Yet just because highly volatile markets might seem concerning doesn’t mean investors always need to panic. Volatility is a natural part of the market, and in some cases, may even work in some investors’ favor. While we can’t necessarily predict when the markets will be highly volatile, understanding what that volatility means and preparing for the corresponding risks may help investors feel a little less panic at the disco.
ROLLER COASTER RIDE
Volatility in the stock market refers to the changes in the price of an individual asset or the overall market. When a security experiences an abnormally wide range of highs and lows in its price, investors call it highly volatile. High volatility in the stock market usually means dramatic fluctuations measured in an overall market index, such as the S&P 500.
One prominent factor that may affect volatility is the news. For example, the results of an election may motivate volatility as investors anticipate potential changes in taxes, trade agreements, or federal spending. Other times, economic news could influence the market, such as reports of inflation data or new economic policies.
There are also unforeseeable events that could affect price movement. Weather events such as drought could affect agriculture futures. Volatility usually represents uncertainty, so when anything out of the ordinary attracts the attention of investors, the markets may illustrate their reaction.
In some cases, the stock market may fluctuate without reacting to any surprising news. This may happen due to a market correction, meaning the market is returning to a more sustainable level, sometimes after a speculative bubble.
Since volatility may represent unusual price movement, investors may look to historical volatility for an index or individual security. Investors may measure historical volatility by calculating the standard deviation from the average price within a certain time period. Although historical volatility does not depict future performance, analyzing it can help investors recognize patterns.
Another way of interpreting volatility is implied volatility. Whereas historical volatility looks at past performance, implied volatility is the market’s forecast of a likely movement in a security’s (such as an option’s) price. Since implied volatility is forward-looking, it helps investors gauge the sentiment about the volatility of a stock or the market. However, implied volatility does not forecast the direction in which an option is headed.
Investors can estimate implied volatility using percentages and standard deviations over a given period of time. Volatility indicators such as Bollinger Bands® may also help illustrate volatility.
A well-known measure of overall market volatility is the Chicago Board Options Exchange (Cboe) Volatility Index, or “VIX.” Sometimes known by the provocative nickname “the fear gauge,” VIX is an index that measures the 30-day expected volatility of the U.S. stock market, based on options in the S&P 500.
FEAR FACTOR STRATEGY
Although some people are nervous with uncertainty or irregular changes, volatility could be beneficial for traders. After all, if the price never moved on a security, a trader couldn’t make a profit. However, high volatility can be dangerous for those who don’t properly manage their risk.
An investor’s strategy may influence his or her attitude toward rapid price movement. On one hand, if you were planning on investing in a certain stock, you might see an opportunity to buy it at a discount during a rapid market decline in the hope that the price may bounce back. However, if the price continues to plummet without returning to its previous price, you might face a loss. On the other hand, you might anticipate a stock to decline and choose to short the stock, making a rise in that stock’s value less than ideal.
When prices are highly volatile, you may not always be able to fully protect yourself from a loss. However, with certain precautions you may be able to limit your losses.
To start, always prepare for trading by developing your strategy for risk management. For one, you might spread some of your risk through diversification by purchasing stocks in different industry sectors or asset classes, though diversification does not guarantee a profit or protect against loss. You can also set up other defenses based on your risk tolerance; for more information, you can view our article on risk management.
Next, consider whether a volatile stock fits within your trading plan. Rather than buying a stock simply because of a lower price, consider if your research suggests whether the stock is worth buying based on strong fundamentals. Finally, you might be able to anticipate potentially volatile trading periods by monitoring the news as well as trends in pre- and post-market trading.
Still, we wouldn’t call a market “volatile” if it wasn’t characteristically unpredictable. Even with protections, you might encounter losses during swings in the market. Nevertheless, with some preparation and a disciplined approach, you can trade even during the most surprising trading periods.
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