How to measure stock price volatility? A question which comes in mind of almost every investor and anaylst.
Whenever an investor is looking to invest in a security/ stock/ etf/ bond, first thing to check the volatility of the security over the years. This helps to determine the level of risk associated with the particular security.
Most commonly a firm which understand the concept of volatility is considered to predict successful results.
Keypoints to this blog
- What do you mean by volatility?
- Key takeaways from the blog
- What is standard deviation method?
- Maximum drawdown method
1. What do you mean by volatility?
Volatility is a reflection of the movement of a particular stock price based on it’s history. It depicts the level of risk associated with a particular stock. If it touches new highs and go extreme lows, it’s called highly volatile stock vs the ones which stays on particular range over the years are low volatility stocks.
Investing in a highly volatile stock doesn’t always guarantees profit as it carries the same amount of risk with it.
2. Key takeaways from the blog
- In this blog we will learn the most common technique to measure stock volatility, standard deviation. Traders uses bollinger bands to study standard deviations.
- Maximum drawdown is another method which is used by asset allocators, speculators and growth ortiented investors to limit their losses.
3. What is standard deviation method?
It shows a standard amount which the stock price has differed from the mean over a specific period of time.
Process : First you have to determine the mean of all prices over a specific period of time. Next is subtract this from each stock point. Difference which you will get is squared, summed and averaged to produce the variance.
To bring the value back to the original data set, it is square root which brings it back to dollar.
Use of Bollinger bands to analyze the standard deviation
Analysts and investors uses a techncial indicator called Bollinger bands to get standard deviation over a particular period of time.
This band comprises three lines, Standard moving average ( SMA ), and other lines of which one placed above and one below the SMA. Now the width of the bollinger bands shows how volatile a stock is. Higher the width, more volatile a stock price is.
4. Maximum drawdown method
Maximum drawdown method is all based on finding the maximum drough a stock went in financial dropdown. Largest historical loss of a security is measured with the difference between peak and trough in a specific period of time.
Investors also prefer to use options to not lose more amount and fix the downside.
Not all volatility is bad for investors, large gains is highly desirable since a fall brings potential huge rise with it.
There are multiple ways to take benefits of large gains while trying to minimize loss from drawdowns.
A stop loss order is another essential tool which is used in order to minimize the loss occurance due to drawdowns. It automatically sells when price falls to a present level.
Hope you got to learn everything from How to measure stock price volatility? Stay tuned for more informational blogs.