Volatility and Risk in Stockmarket Trading

If there is one area that is regularly ignored by CFD traders it is that of volatility, which is often confused with risk. Certainly in terms of grading different types of asset classes, the two are connected, and both the risk and volatility of a government stock for instance will usually be much lower than say a dot.com or emerging market smaller company.

But the bottom line is that risk is related to reward, and it simply measures the amount that it is possible to lose within each investment or trade. Volatility however measures how much prices rise or fall over a set time for each investment issue, sector or share, and this is very useful when constructing portfolios, assessing margin requirements and position sizing.

Standard Deviation – the basic measure of volatility

Standard Deviation is the basic statistical measure of the dispersion of a population of data observations around a mean (average), and is widely used in stockmarket trading, borsa online tips forex and commodity analysis. It is simply the square root of the variance, and is calculated as follows:

1. Establish the mean value over the chosen time period.

2. Measure the deviation of each data point from that mean.

3. Square each deviation (this ensures all the deviations are positive).

4. Total up the squared deviations.

5. Divide that figure by the number of data points less one.

6. The Standard deviation is the square root of that figure.

There are some variations on the way the STD can be constructed, but the above is the usual formula supplied with most trading software systems.

Problems with standard deviation

1. If using short term action, the validity of the STD becomes less certain due to the usual short term randomness in the market.

2. It is a retrospective measurement, and is of little use if there is a major change in volatility due to outside news. Having said that, there are certain technical buy and sell indicators which search for changes in volatility to establish potential new trading opportunities, and here it is very useful.

Implied Volatility

Many traders in the options markets will be aware of the use of implied volatility in terms of option pricing, and here the trader can use both the underlying price of the security and the prices of puts (rights to sell) and calls (rights to buy) to establish an expectation of future or implied volatility.

This creates arbitrage possibilities if the stock, or market, is incorrectly priced compared to underlying options available in it, and these disparities often occur after big price moves or panicky action. The formula for implied volatility is much more complex, but it is an interesting area for more sophisticated players to analyse, as it also includes dividend payments and interest rates.

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