Understanding Volatility

After two over-1000 point drops of the Dow Jones last week, a term has come back into use around markets: volatility. This term is probably unfamiliar for a lot of new investors so we thought we’d take the opportunity to dig in and learn a bit more about it ourselves.

 

Volatility – A statistical measure of the dispersion of returns for a given security or market index.

What does that mean? In essence volatility is a measure of price fluctuations, the larger the fluctuations the higher the volatility. If, in the course of a year, a share trades at a low price of $99 and a high price of $101, then that share has not been very volatile. However, if that same share trades between a low of $50 and a high of $150 the next year, then that share has had a far more volatile year.

 

Why is it important? In a general sense, the higher the volatility, the riskier the security. This is because volatility measures price movements, so if a security is highly volatile there is a higher probability that it quickly drops in price.

Importantly, risk and volatility are not the same thing. Rather than us trying to explain it, Warren Buffett explained why in his 2015 Annual Letter to Shareholders. Check out his explanation here:

https://www.businessinsider.com.au/warren-buffett-on-risk-and-volatility-2015-4?r=US&IR=T

 

Is there a way to track volatility? The most widely followed volatility index is the VIX, which tracks volatility of the S&P 500 (500 biggest publicly traded companies in America). Rather than calculating historical volatility (i.e. looking backwards at how volatile the market was) it tries to measure the market’s expectations of volatility.  It calculates this with reference to the S&P 500 index options.

 

How is volatility calculated? Volatility is measured by calculating the standard deviation of the annualised returns over a given period of time. It isn’t something most investors need to calculate (and neither of us at Equity Mates have ever done it) but if you’re interested it can be calculated using the Standard Deviation function in excel. For a full explanation check out this link:

https://www.investopedia.com/ask/answers/021015/how-can-you-calculate-volatility-excel.asp

 

 

Why was volatility suddenly relevant last week?

For about 18 months markets have enjoyed record low volatility. They enjoyed a slow and steady march upwards without any real dips or corrections. This meant that investors could make a lot of money betting that the VIX would remain low.

A number of financial products were created to allow investors to make this bet on low volatility. The most notable of these was a product created by Credit Suisse, code XIV (or VIX backwards). In periods of low volatility (2016 & 2017) this product had done extremely well for investors, however, when volatility returned to markets last week XIV plunged over 90%.

See the painful chart in all its glory below:

 

Credit Suisse have announced they are going to liquidate XIV and return whatever money is left to investors. A number of pundits have claimed that investors betting on this XIV product actually made last week’s sharemarket drops worse. In a nutshell, it is because when volatility increased, they needed to cover their short volatility (XIV) bet by selling S&P 500 options, essentially betting the market would fall further.

It’s difficult to tell how much truth there is to that theory. What is clear is that investors in XIV will be having nightmares about that chart and what happened last week for years to come.

 

What should I take from this post?

Two things. Firstly, it looks like volatility is back. With more price fluctuations this means more risk, but also more opportunity for cheaper stocks. Secondly, be very careful when investing in leveraged financial products like XIV. For most investors we’d suggest just steering clear (we certainly are!) There’s enough opportunity out there without needing to invest in products like that.

At the end of the day though, regardless of how volatile the market is the most important thing is that you have a consistent process when thinking about investments. Try and buy shares or indexes when they are cheap and have good future growth prospects. Focus on the long term, and don’t get caught up in the day-to-day madness like we saw last week.

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