Some dangers are hidden; some are hiding in plain sight.
© JamesBreyâiStock/Getty Images
When the going is goodâlots of good news, strong economic growth, healthy investment portfoliosâinvestors tend to become complacent. Then out of nowhere, something spooks the markets and sends them sharply lower and highly variable. Such abrupt moves, known as market volatility, can wreak havoc on your portfolio (and your emotions).
Key Points
- Beta measures the historical variability of individual securities relative to a benchmark such as the S&P 500.
- Implied volatility is a snapshot of the marketâs expectation of future price variability, based on prices of listed option contracts.
- The Cboe Volatility Index (VIX) measures the implied volatility of S&P 500 Index options over a 30-day horizon.
What is market volatility?
Besides swings in asset prices, stock market volatility also represents the riskiness of a stock or index. The greater the volatility, the riskier the investment.
If you ever took a class in statistics, youâd recognize volatility as the standard deviation, or how far stock prices move away from their average on an annualized basis. But volatility isnât static. It changes over time depending on many thingsâinvestorsâ risk appetite, changing narratives and contradictory stories about specific companies or sectors, and uncertainty about the economy or geopolitical outlook.
Think of price volatility as a battle between fear and greed. Extremes in fear and greed can cause volatile price movements. When greed is dominant and prices are moving up, you might not consider protecting your portfolio from downside risk. But when fear becomes dominant, you might wish you had a portfolio protection strategy in placeâand you might pay up for some sort of protection. Volatility can be vicious and costly, so keep an eye on it.
How to track market volatility
There are different ways to measure stock market volatility. Three common approaches are beta, implied volatility, and the Cboe Volatility Index (VIX). Beta and VIX values can be found on most financial websites. To find implied volatility values, you may have to look specifically at options data.
Beta. A stockâs beta value indicates how much an assetâs price is likely to move relative to a market index, based on historical price movement. Investors generally use the S&P 500 (SPX), but you can use other appropriate indexes. So, if a stock has a beta of 2.0, itâs an indication the stock has historically twice the variability of the index. Beta thresholds are as follows:
- If beta is between 0 and 1.0, the stock is considered to be less volatile than the market.
- If beta is greater than 1.0, the stock is considered to be more volatile than the market.
- If beta is 1.0, the stock would be as risky as the market. By definition, the SPX has a beta of 1.0
If a stock is twice as volatile as its related index, how much can you expect it to move? Implied volatility may be able to give you some idea.
Implied volatility. There are two types of volatilityâhistorical volatility (or realized volatility) and implied volatility.
- Historical volatility. This looks at the past price movements to measure how much prices deviated from their average over the past year. It gives you an idea of whether a stock has generally seen a lot of up and down movement in the past, or if it has been relatively stable.
- Implied volatility. This indicates how much the price of a stock or index is expected to change in the future, based on the prices of listed option contracts. Youâll often see implied volatility expressed as a percentage. The higher the percentage, the more volatile the stock is expected to be. But implied volatility isnât staticâitâs constantly changing. Think of it as a gauge.
Sometimes stocks may have low historical volatility and high implied volatility. For one reason or another, traders in the options market expect it to make a big move in the future. That could be for company-specific reasons, or it may have to do with overall market volatility, which is another way to monitor volatility.
Cboe Volatility Index (VIX). Financial media channels frequently mention the VIX. Itâs an important gauge of market volatility because it measures the implied volatility of SPX options over a 30-day horizon. If the VIX is low, it suggests investors are confident about the stock market. If the VIX is high, it means investors are nervous. The VIX is often called the fear gauge because fear drives market volatility higher.
But high and low are relative. To better understand the VIX, itâs helpful to look at a historical chart and compare it to the SPX (see below). There are often long periods when VIX is low. But once in a while the VIX, without any warning, may spike.
SPX VS. VIX. Most of the time, particularly during a steady uptrend in the S&P 500 (SPX), the Cboe Volatility Index (VIX) stays below 20. During times of market stress, however, the âfear gaugeâ has risen above 80.
Source: Barchart.com. For educational purposes only.
VIX spikes are rare and correspond to times of crisis. The chart above displays the following properties of the VIX:
- Inverse relationship between VIX and S&P 500 index. The VIX tends to have an inverse relationship with the SPX. Generally, when the index moves higher, VIX decreases, and when SPX moves lower, VIX increases. You can see how, during periods of extreme volatility in 2008 and 2020, the SPX saw notable declines.
- Mean-reverting nature of VIX. After the VIX spikes, it tends to eventually return to its average range. Sometimes the return can be quick, such as after the 2020 spike, but other times it can take a few years. After the 2008 spike, when VIX almost hit 90, it took a few years for it to settle between 10 and 20.
- Volatility regime change. Between 2012 and 2020, the VIX ranged on average between 10 and 20, with an average of about 18. Anytime the VIX rose above 20, investors started to get jittery. In the early 2020s (particularly during the COVID-19 pandemic), the VIX hovered around a higher range, mostly between 20 and 30. Afterward, the VIX returned to its normal sub-20 range. But spikes continue to happen every once in a while.
The bottom line
As an investor, you have to think about your risk tolerance level. Can you tolerate the price swings of high-volatility stocks, or are you more comfortable investing in stocks that are more stable?
Comparing the riskiness of a stock to a benchmark index (beta) and checking how much investors expect the stock to potentially move (implied volatility) can help you decide which stocks to consider investing in, which ones to avoid, when to be invested, and when not to be invested. And if the VIX indicates increased market volatility and youâre not comfortable in a risky environment, you may want to wait on the sidelines until conditions settle down.
As an investor, you canât avoid market volatility. But diversifying your portfolio can help you mitigate the risks over time. And if youâre interested in taking things a step further, learn about the options market. There are options strategies designed for pretty much any market conditionâup, down, and sidewaysâas well as strategies designed to protect your portfolio when the market declines.
This article was most recently revised and updated by Jayanthi GopalakrishnanThis article was most recently revised and updated by Doug Ashburn
