Volatility is a measure of possible returns for given security. In other words, it is a rate at which the price of an asset rises or falls given a particular set of returns. Volatility is measured by calculating the standard deviation of annual returns over a defined period of time.

Volatility plays a crucial role in the financial market because:

Under high volatility circumstances, the trading risks are higher and vice versa. The use of volatility for the pricing of financial assets helps to predict the fluctuations that are likely to occur over the short term. If an asset price fluctuates at a rapid rate within a short span of time, it means the price is likely to be highly volatile. The price of an asset seeing gradual fluctuations over a long period of time tends to be less volatile.

The volatility of financial markets is important from an investor’s perspective since high volatility is associated with high profits or significant losses at the expense of high certainty. Under high volatility, certain traders choose to stay away from the risk while few engage in riskier trading with the hope of higher profits.

Factors affecting volatility

Economic factors such as tax and interest rate policies can influence the volatility of the market significantly. For example, in many countries, when central banks increase or decrease the interest rate for commercial banks, the financial market sees a lot of volatility.

The inflation rate plays a major role in influencing the volatility of the market. For example, a major oil-related event in the oil-producing areas can spike oil prices thereby increasing the volatility in the prices of oil-related stocks.

Bottom line

The higher volatility can impact the portfolios which stresses out the investors seeing their value dropping drastically. This encourages investors to realign their portfolios between stocks and bonds. Market volatility gives a silver lining to the investors to capitalize on such situations.