Volatility in markets: how to protect your investments

Volatility is a measure used to determine the strength of price fluctuations (changes) of an asset or the market as a whole over a short period. In other words, it measures how much the asset's price deviates from the average price value.

Assets with high volatility will have prices that differ significantly from the average price, whereas assets with low volatility will have prices closer to the average value.

Assets with high volatility are considered more  ⚠️ risky. However, some level of volatility is beneficial for traders who aim to profit from price fluctuations.

As a rule, volatility spikes sharply when there are fundamental changes in the financial markets. Such changes include interest rate adjustments, the release of important economic data, and political decisions. You can easily keep track of such events using our economic calendar.

Types of market volatility 📊

Let's look at the difference between historical volatility and implied volatility.

Historical volatility, sometimes called statistical or realized volatility, measures how quickly the price has moved over a certain period, as the name suggests.

On the other hand, implied volatility estimates the likelihood of future 💹price changes of an asset, which can be used to assess future volatility.

There are many methods and indicators used to determine the value of historical or implied volatility. In the following sections, we will review some of the most well-known methods for measuring volatility.

Best volatility indicators 📈

Parabolic SAR indicator

The Parabolic SAR indicator was developed by J. Welles Wilder, a pioneer in technical analysis, for use in trending markets and is therefore ineffective in sideways markets.

This means that to achieve maximum effect, it is necessary to use the Parabolic SAR in tandem with a trend-determining indicator.

Trends can maintain their strength over long periods, but as we all know, they don't last forever. The driving force behind them eventually always wanes.

The indicator is intuitive to use, and its operation can be divided into 4 points:

• A dotted SAR line below the current price indicates an uptrend.
• An SAR line above the current price indicates a downtrend.
• The price breaking above the SAR line signals a buy.
• The price breaking below the SAR line signals a sell.

Standard deviation indicator

Standard Deviation is a statistical measure that determines the dispersion of a particular indicator (i.e., how variable it is) and is often used to measure volatility.

A low Standard Deviation value means that the measured values are close to each other. On the other hand, a high value indicates strong dispersion between them. The Standard Deviation indicator is available by default on both 🖥️MetaTrader trading platforms. Its use for visualizing the volatility level of a particular currency pair is widely applied among traders.

If prices are randomly chosen from a normal distribution curve, about 99.7% of all values will fall within three standard deviations from the mean, 95% within two standard deviations, and 68% within one.

Many traders use the Standard Deviation indicator to determine volatility since the prices of most assets often follow the principle of normal distribution.

It's important to remember that an asset with high Standard Deviation will have high historical volatility.

CBOE Volatility Index (VIX)

The CBOE Volatility Index (VIX), sometimes referred to as the fear index, is a measure of expected volatility in the stock market. Its value is determined by the prices of options in the broader S&P 500 index.

The calculation of the VIX is too complex for analysis in this article; however, if you are interested in this information, you can find step-by-step calculations in the CBOE VIX "White Paper."

An index value below 12 indicates low market volatility, while a value above 20 indicates a high level of volatility. Any value from 12 to 20 is considered normal.

What does volatility mean for traders and investors? 💼

As mentioned above, high market volatility is usually associated with a higher level of risk. However, traders' and investors' opinions on volatility will differ depending on their type and risk tolerance.

For example, a more traditional investor who plans to buy company stocks and hold them for a long period is likely to avoid assets associated with high volatility.

Such an investor wants to purchase a security and simply wait, hoping it will gradually increase in value. Therefore, increased 💸volatility and the associated risk would be unacceptable for them.

On the other hand, many short-term traders, such as scalpers, thrive on high volatility. This type of trader seeks to profit from both the rise and fall in prices of financial instruments. For active traders who can react extremely quickly to price fluctuations occurring within seconds, volatility represents great opportunities.

For them, taking on higher risk means the potential for profit that volatility provides. However, unlike long-term investors, this trading style requires the trader to be present at the trading terminal more frequently and for longer periods.

If you choose to trade in high volatility periods, it is extremely important to remember risk management, such as setting ✅take-profit and stop-loss orders ❌.