Market Participants create strategies and methods to anticipate volatility in the markets, however given the inefficiency of financial markets, getting perfect prediction becomes a myth!

Another interesting factor to note is that different market regimes have different levels of volatility and traders actually create strategies specifically using multiple volatilities.

How Volatility affects Investments & Returns and why is it important for Investors?

To understand volatility, let’s take an example of a news-based event.

Today if an investor invests R100,000 in FTSE/JSE Top 40 Index ETF and the South African Reserve Bank publishes inflation rate higher than market expectation; investors start selling the same ETF heavily. Panicking and assuming that inflation rates will affect growth in the country, investors take this decision.

Price of the FTSE/JSE Top 40 Index are bound to fall and an investment of R100,000 might just be R70-80K post market cool-off. The prices may rebound once there is positive news and investors feel that the ETF has been sold more than enough. This sudden movement in prices is called short-term volatility.

Statistically speaking, a 30% drop and a 30-35% upside took place on the ETF price. This type of fluctuation is very common and cautious investors either buy derivatives to protect against such short-term loss or buy out before the event.

It also brings a very great opportunity to traders who can buy at lower than face value of the asset and sell at higher price. Long term investors buy more when prices drop beyond expected in order to bring down their average price. This is the exact reason why volatility is critical for being a successful investor and risk mitigation techniques should be known before investing in financial markets.

How is Volatility measured and its Types? 

There are different types of volatility and can be measured in different types. Let us understand the important ones in basic:

• Stock specific volatility – Some assets may be generally volatile due to various reasons and have very low co-relation to market movements. Reasons may be due to liquidity squeezing (not enough bid and ask offers), nature of business (might be involved in business not very well understood in the markets) and seasonal stocks (involved in businesses which are season oriented, for example: umbrella manufacturing or Ice-Cream manufacturing companies). 

• Market Volatility – As the name suggests, fluctuation which is going to impact most of the financial assets is known as market volatility. This can be due to a bull or bear run. It might also involve economic or political results and markets are generally volatile during the period. Markets become very unpredictable fundamentally during high market volatility periods, giving traders space for bidding higher prices until the results are out. Once results are out depending on the sentiment, more bidding or heavy shorting takes place. 

• Historical Volatility – The past volatility of an asset helps predict the current or future volatility to an investor. Therefore, it becomes very critical to understand and interpret historical volatility correctly so as to help gauge correct trading strategies. Historical volatility & prices of the JSE listed markets can be fetched from JSE’s Historical Data. However, in order to get minute by minute data, it is better to purchase paid historical data from brokers directly. 

• Implied volatility (IV) – Traders usually get confused and conclude implied and historical volatility are similar. However, this is far from being true. IV is the expected future volatility calculated based on current parameters rather than historical. Therefore, the IV between today and tomorrow might be different for an option expiring a week later. IV tends to rise closer to the maturity or expiry of bonds or derivatives. This is due to higher anticipation of price volatility during the period. 

• Volatility Index – Financial markets are very interesting in terms of calculating everything ranging from fear to sentiment. How can volatility stay behind you ask? Volatility Index is a benchmark used in different markets geographically to gauge in the currently volatility in the market. In the US Markets, it is known as VIX (Volatility Index). South Africa uses SAVI (South African Volatility Index). It is immensely useful for traders to understand the volatility in the current markets and risk their bets hoping for positive outcomes. We will learn in depth about this below!

 Importance of Volatility Index and how can you trade/Invest in it? 

Financial markets act as an innovation hub in itself, when it comes to launching new products. When CBOE introduced VIX ETFs and options, little was it known it will be such a popular product.

CBOE VIX ETF uses the implied volatility (IV) of the next 30 days to gauge and indicate a price. It shows the fear and stress levels, markets are going through. Higher the IV of VIX Index, higher the S&P 500 Index price falling and vice versa.

Traders can buy ETF and option/future contracts to speculate on volatility. South African traders can speculate on volatility of VIX through Volatility 75 Index brokers that offer it as CFD. Also, when a trader has a position which can change price direction quickly, VIX derivatives and ETFs can act as tools for hedging risk.

Given it calculates the entire volatility of the market, a vast portfolio of assets can be traded following the VIX Index. Traders and Investors can optimize portfolio risk metric by investing in VIX contracts, thereby helping stabilize portfolio value during heavy downfall in market asset prices.

Factors affecting Volatility in the markets

Now, that we have understood what volatility is and how traders can trade using it. Let’s understand, what are the main factors affecting volatility in the markets:

1. Market Sentiment – Markets are inefficient and any new news about a particular organisation, may affect volatility. Take for example, if the CFO of a firm is caught by market regulators for inflating profit numbers, the prices of such firm in every asset class will fall involving heavy volatility. Therefore, news or market sentiment is very important while investing.

2. Economic and Political Policy – As we know Financial Markets are backbone for any economy, market relies heavily on economic and political policies. It is well known, when a new government is formed or when central banks increase their repo, reverse repo rates; markets turn volatile. These impacts have macro-economic implications too, when US or China increases or decreases key economic parameters, it impacts the financial markets all over the world. It is due to dependency or import/export relations with the said country, and foreign investors investing in other countries may not feel very safe due to changing policies.

3. Major unprecedented event – The 2001 dotcom bubble, 2007-08 Financial crisis and the recent 2020 coronavirus pandemic are all major unknown events. These market events usually cause crashes causing extreme market volatility. Traders or Investors lose or make cash heavily during these periods. Investors like Michael Burry or Bill Gurley made millions during these periods. Usually markets are volatile, until the lower bottom of every benchmark is touched.

4. Profit/Loss Announcements – When corporations announce quarterly or annual P/L results, markets are usually volatile as the results are still unknown at the moment. Post announcement, markets cool off or become more volatile if the results don’t match the expectations. However experienced traders, create strategies based on the 1–2-day volatility in an asset before the announcements.

Therefore, investors much understand how important and interesting volatility is for the markets. It is the soul of every trading strategy which provides opportunity every time it occurs!