What it means
Volatility is usually calculated as the standard deviation (a statistical measure of how widely numbers scatter around their average) of a share's returns. A higher figure means returns are spread over a wider range, so the outcome you actually experience is harder to predict.
It says nothing about direction, because big gains and big falls both count as volatility. For a business, volatility matters in several practical ways.
It affects the cost of employee share awards, the pricing of options, the return investors demand for holding the stock, and how nervous a board becomes when the company's market value swings around. Two flavours are worth knowing.
Historical volatility looks backwards at how much the price has actually moved, while implied volatility is the figure that option prices suggest the market expects in future. When implied volatility is high, options become more expensive.
Volatility is normally quoted on an annual basis so that different shares can be compared fairly. Shorter-period figures are scaled up by multiplying by the square root of the number of periods in a year, a standard rule that assumes returns are independent from one period to the next.
Volatility is not the same thing as risk of permanent loss. A share can be very volatile and still recover, and a calm share can still be a poor business.
It is a convenient summary of price variability, not a full measure of danger. Small and young companies, and shares in cyclical or heavily indebted businesses, tend to show higher volatility.
Large, stable, cash-generating companies often show lower figures, though extreme market events can lift volatility across the board at once.
In practice
Real-world examples
Example 1
A company grants its executives share options and needs a fair value for its accounts. The valuation team feeds the share's volatility into an option pricing model, and a higher volatility input produces a higher option cost.
Example 2
An investor with a short time horizon compares two technology shares with the same expected return. She chooses the one with 18% volatility over the one with 45% because she cannot afford a sudden drop in the next six months.
Example 3
A treasury manager at a manufacturer holds shares in a supplier as a strategic stake. When the supplier's share volatility jumps after a profit warning, the manager asks the risk committee to review whether the holding still fits the company's limits.
Think of it
Stock volatility is like riding a transport vehicle. Low volatility is a smooth train ride along a straight track, while high volatility is riding a roller coaster through a severe storm.
Formula
Calculation
Annualised volatility = Standard deviation of periodic returns x Square root of periods per year
Suppose a share's quarterly returns have a standard deviation of 10%. There are 4 quarters in a year and the square root of 4 is 2. Annualised volatility = 10% x 2 = 20%. As a rough guide, for a $100 share this suggests that in about two years out of three the price one year later would sit within one standard deviation of today's level, which is between 100 x (1 - 0.20) = $80 and 100 x (1 + 0.20) = $120.Case study
Seen in the real world
Ashgrove Biosciences is an illustrative, fictional drug developer whose share price moved sharply on trial news. Its finance director noticed that the share's annualised volatility was about 60%, far above the market average her board was used to.
When she modelled the company's employee share plan, the high volatility made each option very expensive in accounting terms. She presented two redesigned plans to the remuneration committee, one with fewer options per person and one with longer vesting.
The committee chose the version with fewer options. In this illustrative story the lesson was that volatility is an input that flows directly into costs, not only into investor sentiment. The finance director also added a note to the annual report explaining the assumption behind the volatility figure. She wanted readers to understand that the cost estimate would move if the share became calmer or wilder, and that the number was a judgement and not a certainty.
Watch out
Common mistakes
- Treating volatility as a measure of direction, when it only measures how wide the swings are in either direction.
- Comparing a monthly volatility figure with an annual one, which makes the monthly number look much smaller than it really is.
- Assuming past volatility will repeat, when markets can move from calm to stormy very quickly.
Questions
People also ask
Is higher volatility always bad?
No, it means higher uncertainty, which is bad for someone who needs the money soon but can be acceptable or even desirable for someone seeking higher long-term returns.
How does volatility differ from beta?
Volatility measures the total swings in one share, while beta measures how much the share tends to move relative to the overall market.
Why do option prices rise with volatility?
A bigger range of possible future prices raises the chance the option ends up well in the money, while losses on the option are capped at its cost.