Volatility is a statistical measure of the dispersion of returns for a given security or market index, often used to assess risk.
Understanding volatility
Volatility represents how widely prices fluctuate over a specific time period. High volatility means the price of an asset changes rapidly and unpredictably over a short period. Low volatility means the price remains relatively stable. Traders and investors use this metric to estimate the potential for future price movements.
The mathematical calculation of volatility usually involves finding the standard deviation or variance of annualized returns over a given period. Financial analysts calculate historical volatility based on past market prices. They also calculate implied volatility, which looks at the prices of options contracts to determine market expectations for future price changes.
For Elephants navigating global financial markets, volatility is a standard gauge of risk. An asset with high price fluctuations carries a higher risk of loss along with the potential for higher gains. Stable assets present lower risk and generally offer lower returns. Asset managers adjust portfolio allocations based on the measured volatility of equities and bonds to match specific risk profiles.
Example
Imagine two publicly traded companies that supply agricultural feed to elephant sanctuaries around the world. The first company, Jumbo Feed Co., has a stock price that moves between $49 and $51 over the course of a year. The returns on this stock show low dispersion, meaning Jumbo Feed Co. has low volatility. The second company, Savannah Supply Ltd., experiences erratic supply chain issues and frequent changes in executive leadership. Over the same year, its stock price swings wildly between $20 and $80. The returns on Savannah Supply Ltd. show high dispersion. An investor looking for stable value would view Jumbo Feed Co. as a lower-risk investment, while a trader seeking rapid price movement might prefer trading shares of Savannah Supply Ltd.