Trading is made up of several different aspects, and it’s the main aim of every trader to effectively understand these crucial components, to ensure their trades are as well-informed as possible.
Among the many different parts that make up trading, one of the most essential aspects is the volatility of the markets.
Regardless of your preference in trades – such as traditional or contracts for difference (CFDs) – or your choice of market – foreign exchange (forex), commodities, or stock market – volatility will be a vital factor in how you conduct your trades.
For example, if you were trading with leverage on your chosen platform – such as leveraged trading on Skilling, for instance – volatility could be the main factor that determines whether you receive substantial profit or loss.
Once you understand how volatility works, you can implement your knowledge into more accurate, strategic trades.
Read on, to learn what market volatility is, as well as why it’s important and what affects it.
What is market volatility?
Market volatility measures the variance between possible returns for any given market index, over a period of time. In simpler terms, it’s a measurement of how unpredictable and rapidly changing movements are in a market.
Market volatility can be measured in various ways, but the most common is through standard deviation. First, a moving average is established, which is essentially the average returns of a market over a certain period. Standard deviation is then used to establish each individual return of assets, and show how spread out they are in comparison to the moving average.
For instance, a market that often shows minimal change in asset price values, with the majority of returns being close to the average, would be considered to have low volatility. In contrast, a market that is constantly fluctuating up and down, and is susceptible to sudden changes, would be considered to have high volatility.
Why is market volatility important?
Market volatility is essential for traders, because it’s a good way of measuring the risk involved in a trade.
In order to profit from trades, the aim is to make the most accurate predictions of where market prices are likely to move, so you can open the appropriate trading position to yield profitable returns.
It’s often much easier to make more accurate predictions on markets that show minimal change in price movements. They usually have clearer trends and direction of movement, so the chances of the prices following a steady pattern are higher.
However, with more volatile markets, the prices could change rapidly at any time. Therefore, accurate speculation is much harder, for there’s more unpredictability in the market price movements, and less chance of them following a steady pattern.
As a result, more volatile markets elicit more trade risk, as you’re much less certain that trades won’t suddenly go against your favour.
Therefore, it’s important to assess the volatility of markets before executing every trade, as this will help you make more informed decisions, and potentially increase your chances of trade profit.
What affects market volatility?
Market volatility can be determined by various things, and markets can go through certain periods of high or low volatility depending on these. These factors include, but are not limited to:
- Political climates – Countries going through periods of political instability, such as wars, can increase volatility across markets.
- Economic conditions – Economic conditions can cause uncertainty, such as an increase in inflation rates or changes in monetary policies, which will increase volatility.
- Company performance – Volatility can be applied to both markets and individual assets. For instance, a company going through drastic restructuring will likely increase the volatility of its asset price movements.
Volatility neither dictates an incline or decline in price movements, but simply declares how likely either is to occur. With certain factors in play, the level of volatility in market can be greatly increased or decreased for a certain time period.
Understanding market volatility is key to executing the most accurate trades. Now that you have this knowledge, you can conduct more strategic approaches to trading, that increase your chances of profit, and minimise trade risk as much possible.