Financial markets are by nature volatile. One day the price is high, the next day it drops drastically. Whether it is the stock market or forex market, price fluctuations can either lead to huge gains or great losses. The good thing is that investors in the financial markets understand the volatile nature of share and forex prices. As such, they know that volatility in the financial markets can either present the risk of losses or opportunity for growth. This could happen on a daily, monthly, quarterly or yearly basis. Read on to gain an understanding of the risks and opportunities inherent in the volatility of the financial markets.
What Is Volatility?
Volatility defines the extent to which the average return on stocks or forex changes either upwards or downwards. In most cases, the standard deviation is used to measure volatility in financial markets. The bigger the standard deviation, the more volatile the market is. Higher volatility means that stock or forex prices are moving too far from the mean price for a given period of time.
In the securities market, higher volatility means investing in particular stocks is highly risky. As such, investors could either make huge gains or incur great losses. Thus, the relationship between volatility and risk has to do with how far the expected returns move from the average.
What Causes Volatility?
There are many reasons for the volatility that’s often witnessed in the financial markets. The following are some of the major reasons for the volatility witnessed in financial markets:
1. Political Developments
Politicians have a great say on federal spending, trade agreements, tariffs, and taxes. Because of that, financial markets usually respond to the happenings in the political arena. Simple legislation or political speech could either cause a rise or decline in the stock and forex markets.
2. Economic Indicators
From time to time, the government releases economic data of all sorts showing the overall health of the economy. Data indicating economic growth is likely to cause positive reactions in the market. This will make the market less volatile. On the other hand, missed economic targets could lead to a highly volatile situation. Positive reports may include economic growth, the creation of more jobs, and so on. Negative economic data could be about increasing inflation, interest rates, and so on.
3. Hits or Misses In Public Relations
Volatility doesn’t have to affect the entire market. It could affect a single company due to the release of either positive or negative information. When news about a positive development in the company comes out, the result is improved stock prices and less volatility. Negative news concerning bad executive behavior, data breaches, and product recalls may cause high volatility.
4. Volatility Abroad
In today’s interconnected economy, what happens in the rest of the world has an impact on local financial markets. Factors such as regime changes, rebellions, political upheavals have an impact on the flow of investments between nations. The effect is a highly volatile market. For instance, Brexit is causing high volatility in financial markets across Europe.
Risk and Opportunity: How Does Volatility Affect the Financial Market?
Without a doubt, volatility has a huge impact on the performance of financial markets. In the stock market, volatility rises or drops depending on the performance of the market. As such, a rise in the stock market leads to a decrease in volatility and a drop in the stock market causes a contrary effect. An increase in market volatility means increased risks and decreased returns.
According to a 2011 report by Crestmont Research, higher volatility is characteristic of declining markets while lower volatility is mainly witnesses in rising markets. Thus, being aware of the prevailing market volatility can help you decide can help you know when to invest or diversify your investment portfolio.
When unanticipated, volatility is risky in the short-term. In the long-term, volatility could mean more investment opportunities. The first reaction among investors is to dread possible losses from the situation at hand. Thus, investors would prefer to hedge their investments against the risk of further downward movement in stock and forex prices. As a result of many investors opting to sell, the prices increase creating an opportunity to gain some profits.
Generally, highly volatile financial markets are more rewarding for investors in the long run. They present an opportunity for the diversification of investment portfolios for those looking to avoid the growing risk. Volatility creates opportunity in the following ways:
- Widening the range within which to implement investment strategies. When an investor anticipates a currency price to be within a given range in the future, he or she can choose to put an option on one extreme of the range or the other. In a less volatile market, this range isn’t as broad. However, a spike in volatility broadens the range and increases the likelihood of the investor earning some good profit.
- Elevation of the skew for financial markets thus creating an opportunity to make upside breakouts. The fact that the market is skewed to the extreme does not mean that it won’t recover in the other direction. Traders have the opportunity to purchase a call option thus putting the market on the road to recovery through a put option sale. Compared to call options, put options are known to trade at a premium thus enabling great returns.
- Taking advantage of expected price hikes in the long-term. By their nature, prices of options are usually prone to higher volatility in the long-term. That’s owing to the uncertainties of the long-term future. Thus, investing for the long-haul could prove to be more profitable.
Thus, increased volatility is an opportunity for you to try out alternative strategies. These could be geared towards making your investment portfolio more asymmetrical or creating a buffer to protect you in case of persistent weakness.
It is clear that volatility can present a great risk for investors in the financial markets. The likelihood of huge losses is real, especially for those investing in the short term. If you have no problem taking risks, market volatility could create an opportunity for you. You could either diversify your investment portfolio or take advantage of future price hikes to make a kill.