What Is the Best Measure of Stock Price Volatility?

Volatility is a reflection of the degree to which price moves. A stock with a price that fluctuates wildly, hitting new highs and lows or moving erratically, is considered highly volatile.

Traders look at its historical volatility when selecting a security for investment to help determine the relative risk of a potential trade. Numerous metrics measure volatility in differing contexts and each trader has their favorites. A firm understanding of the concept of volatility and how it’s determined is essential to successful investing.

Key Takeaways

• Volatility refers to how quickly markets move and it’s a metric that’s closely watched by traders.
• Standard deviation is the most common way to measure market volatility.
• Maximum drawdown is another way to measure stock price volatility and it’s used by speculators, asset allocators, and growth investors to limit their losses.
• Beta measures volatility relative to the stock market and can be used to determine the diversification benefits of other asset classes.
• The CBOE Volatility Index (VIX) is a common metric used to measure the expected volatility of the S&P 500.

Why Volatility Is Important

A highly volatile stock is inherently riskier but the risk cuts both ways. The chance for success is increased as much as the risk of failure when you invest in a volatile security. Many traders with high risk tolerance look to multiple measures of volatility to help inform their trade strategies.

Standard Deviation

The primary measure of volatility used by traders and analysts is the standard deviation. This metric reflects the average amount a stock’s price has differed from the mean over some time.

It’s calculated by determining the mean price for the established period and then subtracting this figure from each price point. The differences are then squared, summed, and averaged to produce the variance. The formula for standard deviation is as follows:

$begin{aligned}&text{Standard Deviation}=sqrt{frac{sum^n_{i=1}(x_i-bar{x})^2}{n-1}}\&textbf{where:}\&x_i=text{Value of the }i^{th}text{ point in the data set}\&bar{x}=text{The mean value of the data set}\&n=text{The number of data points in the data set}end{aligned}$​Standard Deviation=n−1∑i=1n​(xi​−xˉ)2​​where:xi​=Value of the ith point in the data setxˉ=The mean value of the data setn=The number of data points in the data set​

The standard deviation is calculated in a few steps:

1. Find the mean of all data points by adding all data points and dividing by the number of data points.
2. Find the variance of each data point by subtracting each data point from the mean (from Step 1.)
3. Square each variance, then add all squared variances together.
4. Divide the sum of squared variances (from Step 3) by one less than the number of data points.
5. Take the square root of the variance (from Step 4); this is the standard deviation.

The variance is the product of squares so it’s no longer in the original unit of measure. Price is measured in dollars so a metric that uses dollars squared isn’t very easy to interpret. The standard deviation is therefore calculated by taking the square root of the variance. This brings it back to the same unit of measure as the underlying data set.

Note

The standard deviation is by far the most popular measure. People usually mean standard deviation when they speak of volatility.

Bollinger Bands

Chartists use a technical indicator known as Bollinger Bands to analyze standard deviation over time. Bollinger Bands are composed of three lines: the simple moving average (SMA) and two bands that are placed one standard deviation above and below the SMA. The SMA is essentially a smoothed-out version of the stock’s historical price but it’s slower to respond to changes.

The outer bands mirror those changes to reflect the corresponding adjustment to the standard deviation. The standard deviation is shown by the width of the Bollinger Bands. The wider the Bollinger Bands, the more volatile a stock’s price is within the given period. A stock with low volatility has very narrow Bollinger Bands that sit close to the SMA.

A simplified price chart of the SPDR S&P 500 ETF Trust (SPY) with Bollinger Bands is shown in this example. The stock traded within the tops and bottoms of the bands over a one-month range for the most part but it dipped below the lower band for about one week. The price was between approximately $495 and $522 per share during the month.

Bollinger Bands are often used as an indicator of the range a security trades between with the upper band limit indicating a potentially high price to sell at and the lower band limit indicating a potentially low price to buy at.

Important

Most traders are most interested in losses so a downside deviation that only looks at the bottom half of the standard deviation is often used.

Maximum Drawdown

Another way of dealing with volatility is to find the maximum drawdown. This is usually given by the largest historical loss for an asset, measured from peak to trough, during a specific period. It’s possible in other situations to use options to make sure that an investment won’t lose more than a certain amount. Some investors choose asset allocations with the highest historical return for a given maximum drawdown.

The value of using maximum drawdown comes from the fact that not all volatility is bad for investors. Large gains are highly desirable but they also increase the standard deviation of an investment. There are ways to pursue large gains while trying to minimize drawdowns.

Important

A maximum drawdown may be quoted in dollars or as a percentage of the peak value. The underlying prices as dollar maximum drawdowns may therefore not be a fair comparable base when comparing securities.

Many successful growth investors such as William J. O’Neil look for stocks that go up more than the market in an uptrend but stay steady during a downtrend. The idea is that these stocks remain stable because people hold on to winners despite minor or temporary setbacks.

A stop-loss order is another tool commonly employed to limit the maximum drawdown. The stock or other investment is automatically sold when the price falls to a preset level but gaps can occur when the price moves too quickly. Price gaps may prevent a stop-loss order from working in a timely way and the sale price might still be executed below the preset stop-loss price.

Beta

Beta measures a security’s volatility relative to that of the broader market. A beta of 1 means that the security has a volatility that mirrors the degree and direction of the market as a whole. The stock in question is likely to follow suit and fall by a similar amount if the S&P 500 takes a sharp dip.

Relatively stable securities such as utilities have beta values of less than 1, reflecting their lower volatility as compared to the broad market. Stocks in rapidly changing fields, especially in the technology sector, have beta values of more than 1. These types of securities have greater volatility.

Note

The beta of the S&P 500 index is 1. A higher beta indicates that that stock will move more than the broader market when the index goes up or down.

A beta of 0 indicates that the underlying security has no market-related volatility. Cash is an excellent example if no inflation is assumed. There are low or even negative beta assets that have substantial volatility that is uncorrelated to the stock market, however.

Is High or Low Volatility Better for Stocks?

Many day traders like high-volatility stocks because there are more opportunities for large swings to enter and exit over relatively short periods. Long-term buy-and-hold investors often prefer low volatility, however, where there are incremental, steady gains over time. It can generally signal increased fear of a downturn when volatility is rising in the stock market.

What Is Considered Average Stock Volatility?

There are various ways to measure the average volatility. When looking at beta, the S&P 500 index has a reference beta of 1 so this is also the average volatility of the market.

Investors can look to the CBOE Volatility Index or VIX on an absolute basis. This measures the average volatility of the S&P 500 on a rolling three-month basis. Some traders consider a VIX value greater than 30 to be relatively volatile and under 20 to be a low-volatility environment. The long-term average for the VIX has been just over 20.

How Can I Trade Changes in Volatility?

Those looking to speculate on volatility changes or to trade volatility instruments to hedge existing positions can look to VIX futures and ETFs. Options contracts are also priced based on the implied volatility of stocks or indices and they can be used to make bets on or hedge volatility changes.

How Do You Find the Implied Volatility of a Stock?

Implied volatility is determined using computational models such as the Black-Scholes Model or the Binomial Model. These models identify factors that may impact an equity’s future price, determine outcome likelihoods, and price derivative products like options based on their findings.

The Bottom Line

There are different ways to measure volatility and each is better suited for specific needs and preferred by different traders. Standard deviation is the most common but other methods include beta, maximum drawdowns, and the CBOE Volatility Index. Take the time to find out what works best for you and your trading style.