What it means
Volatility is about dispersion, not direction. A share that rises 8% one month and falls 7% the next is volatile, and so is one that falls 8% then rises 7%, even though the two end up in very different places.
What the number captures is how far outcomes tend to stray from the average. There are two distinct versions and they are frequently confused.
Historical or realised volatility looks backwards at what actually happened to prices, while implied volatility is derived from option prices and reflects what the market expects to happen. The gap between them is itself a traded quantity.
Volatility matters commercially because it drives the cost of protection and the size of buffers. Insurers, banks and treasurers all size their capital and hedging around expected variability, and a business with volatile cash flows needs a larger cash reserve or a bigger credit facility than an otherwise identical business with steady flows.
Convention matters when reading a figure. Volatility is almost always quoted as an annualised percentage, and daily figures are scaled up by the square root of the number of trading days in a year, typically 252.
Quoting a daily number as though it were annual understates risk dramatically. The important limitation is that standard deviation treats upside and downside moves identically.
Most investors do not mind a surprise gain, which is why measures such as downside deviation, value at risk and maximum drawdown are often reported alongside it. Volatility also says nothing about the risk of rare extreme events, which real markets produce more often than a normal distribution would suggest.
In practice
Real-world examples.
Example
A finance director comparing two potential acquisitions notes that the first target's monthly revenue has a standard deviation of 4% and the second's is 19%, and factors the difference into the working capital facility she will need after completion.
Example
An investment committee reviewing two funds with identical five-year returns picks the one with lower volatility, because its trustees would be forced to sell during a deep drawdown to meet pension payments.
Example
A commodity trading desk sees realised volatility in natural gas jump from 30% to 80% ahead of a cold snap and cuts position sizes so that its daily loss limit is not breached by normal price swings.
Think of it
“Volatility is how much prices swing around-the magnitude of price changes.
Formula
Calculation
Volatility = Standard deviation of periodic returns, then annualised:
Annualised volatility = Daily standard deviation x Square root of 252
Take five daily returns for a share: +1%, -2%, +3%, 0% and -1%. The mean return is (1 - 2 + 3 + 0 - 1) / 5 = 1 / 5 = 0.2%.
The deviations from that mean are 0.8, -2.2, 2.8, -0.2 and -1.2 percentage points. Squaring each gives 0.64, 4.84, 7.84, 0.04 and 1.44, which sum to 14.80. Dividing by four (one fewer than the number of observations, the sample convention) gives a variance of 3.70, and the square root of 3.70 is a daily standard deviation of 1.92%.
Annualising: 1.92% x 15.87 = 30.5%. So this share is running at roughly 30% annualised volatility, which would be considered high for a large listed company and unremarkable for a small growth stock.Case study
Seen in the real world.
This is an illustrative, fictional case. Marden Bright Foods, an invented ready meals producer, discovered that its input costs were far more volatile than its selling prices, because supermarket contracts fixed shelf prices for six months while its main ingredient repriced weekly.
The finance team measured the volatility of the ingredient cost and found an annualised figure near 45%, against roughly 3% for its own realised selling prices. That mismatch, not the average cost level, was what produced two loss-making quarters out of the previous eight.
Marden Bright responded by aligning the two clocks rather than trying to forecast prices. It negotiated three-month rather than six-month retail pricing on its largest lines and hedged part of the ingredient exposure with forward contracts. Average margin barely moved, but the quarter-to-quarter variation in gross profit fell by more than half.
Watch out
Common mistakes.
- Treating volatility as identical to loss, when it simply measures the spread of outcomes in both directions.
- Comparing a daily volatility figure with an annual one, or mixing monthly and annual numbers in the same table without scaling them.
- Assuming past volatility predicts future volatility, when it tends to cluster in bursts and can shift regime very quickly.
Questions
People also ask.
What is a normal level of volatility for shares?
Broad equity indices have often run somewhere in the region of 12% to 20% annualised, with individual shares typically higher and government bonds considerably lower.
Is low volatility always better?
Not always, since assets with very low measured volatility can be illiquid or infrequently valued, which masks risk rather than removing it.
How do implied and realised volatility differ?
Realised volatility is calculated from actual past price moves, while implied volatility is backed out of current option prices and represents the market's expectation.
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