The best mental image that I could come up with to explain volatility is the mechanical bull. For those of you who don’t know what a mechanical bull is, the mechanical bull is basically an excuse for drunk men to watch drunk girls flail around wildly. But volatility in the markets is the same idea, nothing to do with drink girls, but there is lots of unpredictable price movement.
What is Volatility?
Keep picturing that mechanical bull. It moves unpredictably and erratically. When the price of an asset moves up one day then down the next few days, then up for a month, then down again, that’s called volatility. Volatility is the measure of variation of the price of a financial instrument over time. Volatility is used to quantify asset risk of whatever financial instrument you are looking at over a specific period of time.
How to Measure Volatility
So you might want to be able to measure the risk by calculating volatility. But I have good news, you don’t have to measure volatility. The Chicago Board of Options exchange already has a way to measure volatility using the VIX, or the Volatility Index. The VIX tracks the speed of stock price movements in the S&P 500. Normally when the VIX is at a high, and investors fear is high, the S&P 500 is low.
How Can I Use Volatility in Trading
Price volatility presents a great opportunity for investors to buy low and sell high. More advanced traders will use options and volatility arbitrage to trade a delta neutral portfolio of an option and its underlying asset. But that’s a post for another day. For now just know that options are one way to trade volatility. A stock with a high beta may be exciting for a trader looking to benefit from large swings in the price versus the overall market, but you have to be careful when riding that bull, cause 9 out of 10 riders fall off.*
How do you trade volatility?
*This is a completely made up statistic.