Trading: what is volatility?

One of the fundamental aspects in trading, both analytically and operationally, is that of volatility. Volatility is an element that in trading is often mentioned in adverse market conditions: especially during market crashes we hear this term very often.

In fact, volatility is a very recurring aspect of trading and one that more experienced traders use to their advantage in all market conditions. Let’s see together what it is.

Volatility, what it is and what it means "Volatile Market"

When we think of the concept of volatility, we are reminded of that physical quality that is associated with the gaseous material, with something that is materially dispersed in space with a certain ease. The more a material is volatile, the more we have the sensation of dealing with something that “expands” or “disperses” even in a disordered in space way.

In finance, the concept of volatility is very well associated with the concept of dispersion: volatility indicates the average percentage change of a financial instrument, or intensity and strength of the fluctuations over the course weather. The more a financial instrument is volatile and the more its trend is “chaotic”, sometimes even erratic, but basically it tends to be very variable over time. The more you have to deal with a financial instrument with an uncertain performance, unstable and subject to strong variations, the more likely it is that this is a very volatile financial instrument.

In finance, this concept extends to both single instruments and particular markets and is a fundamental element at an analytical level for establishing investment choices, both in the short and long term. To give a very practical and current example, a volatile market is a market that moves a lot, especially when there are bearish movements: the Bitcoin for example is a very volatile instrument, because its percentage changes, whether they are daily or monthly, they are very large compared to other instruments.

Volatile instruments par excellence are shares and equity indices. On the other hand, currency exchanges, mistakenly mistaken for very volatile instruments due to the financial leverage applied by brokers, are actually highly low volatile instruments by definition.

Volatility and liquidity, a fundamental relationship

We have seen how the concept of volatility is closely linked to the strong fluctuations seen in the market, but why do they occur and why is one market more volatile than another?

Very simply we have to introduce the concept of liquidity, an element that is closely linked to volatility and is the main cause, especially in particular market conditions such as market “crash”. Liquidity indicates that property of the market which allows ease of trading and is characterized by a large number of market buyers and sellers along with a large amount of trading volumes.

The more a market/instrument is liquid, the more exchanges there are and the more a market is healthy. To give an example, the currency market, the largest market in the world available to the public retail, is a very liquid market by definition as it exchanges money for money. It follows that the Forex (currency) market, being a very liquid market, is also on average not very volatile.

On a practical level we can assume that a liquid market is also a healthy market and at the same time not very volatile. A very different market from Forex, especially in terms of liquidity and consequently volatility, is the cryptocurrency market: this is by definition a not very liquid market as the fluctuations present are very strong, therefore an index of a market "dangerous".

We said before that a liquid market is a healthy market, it follows that a not very liquid market is a unhealthy market and therefore volatile. Volatility also tells us the health of an instrument or a market at a given time. For example, in recent months we have seen a very volatile stock market, this is precisely due to a decrease in liquidity due to the increase in interest rates by central banks, basically exchanges have become more expensive and therefore less frequent. Less liquidity equals more volatility.

Volatility and the health of the market

Volatility is fundamental for several reasons: volatility tells us how an instrument is dangerous, therefore an instrument characterized by high volatility is an instrument in which a trader will tend to invest less capital than an instrument with less volatility. As for intraday traders, the concept according to which traders exploit volatility is true, but these are exceptions and particular conditions, here we are talking about volatility as a general concept and as a useful notion to understand what it tells us on an analytical level.

Basically, even if we could deepen much more on this topic, volatility indicates the state of health of a financial instrument and the more it is volatile and the more it is to be defined as not very liquid and dangerous. Another important thing to underline is the fact that some very liquid instruments, such as currency exchanges, can go through moments of strong volatility within a single day, consequently we are talking about volatility in broad sense at the temporal level.

Basically, when we see strong swings on some markets compared to others, we can safely talk about volatility and when we talk about volatile instruments we are talking about instruments that are more “dangerous” than others. To give a clear example, a very volatile instrument has always been Bitcoin, a very liquid and highly speculative instrument, highly volatile both in the short and in the long term.

This is to be considered an unhealthy market compared to classic currencies, such as Euro or Pound, as the fluctuations are not comparable in terms of intensity, we are talking about two completely different worlds. From this perspective, volatility also tells us how it is behaving and how a market generally behaves. As you can guess, volatility is much more important than you think.