The volatility explained

Mar 1, 2020

We discussed it briefly in a previous article : markets are no fans of epidemics, political surprises and any other form of macro-economic development that can lead to uncertainty. All the more as it is unclear whether massive injections of cash by the central banks will be enough to stop the hemorrhaging. If the economy is voluntarily brought to a halt to stop the virus from spreading, the only way to kickstart it again is to put an end to the epidemic.

Unsurprisingly, the stock markets globally are agitated, and most have registered significant drops last week. Entire industry sectors have been affected : tourism, transportation, luxury goods... are all sectors in which the Chinese economy plays a major role. This uncertainty is reflected in the financial world by an increase in volatility. Let us explain how.

Highs and lows

Let's start with the formal definition of volatility, which is "a statistical measure of the of returns for a given security or market index. In most cases, the higher the volatility, the riskier the security". Said differently, the price of an asset is volatile if it varies a lot and frequently. The more it fluctuates, the more the asset can be considered as risky.

Here, the two lines have the same average growth path, but the red line is substantially more volatile than the green one. Consequently, investing in a volatile asset represents a higher potential risk for gains or losses. From one day to another, the security can be worth much more, ... or much less.

A practical case study : Tesla vs. Fiat

In the car industry, let's compare the disruptive Tesla, which is betting the farm on its technical innovations, with Fiat-Chrysler, one of the oldest and largest car makers, selling slightly less than 5 million unites per year.

An investor who would have bought Tesla shares at the start of the year would have seen this investment more than double in value, with the share price rising from $ 430 to more than $ 900... before losing 25% of the value, last week alone. Conversely, an investor in Fiat would have been in a meaningfully different position. Whilst the Tesla stock was going through the roof, that of Fiat moved modestly lower during the first few months of the year, from €13 to €12 approximately. But last week, its price "only" dropped by 7%.

Currently, the volatility of Tesla's stock price is substantially higher than that of Fiat's, and the timing with which you purchase or sell this security can make all the difference in the world.

Volatility changes over time!

But what holds true today may not be the case tomorrow, because the volatility of a certain asset is not constant. During periods of strong investment, high indebtedness and/or strategic change, the share price of a company is likely to increase. By contrast, during phases of stable revenue generation, combined with debt reduction efforts, the price of the same security is likely to evolve more stably.

But when "volatility" is mentioned by the financial press in general terms, reference is made to the overall level of volatility of the market or markets. Which has strongly risen recently, as stock markets corrected quite brutally.

The "fear gauge"

The most followed volatility index is the one quoted on the Chicago stock exchange, which is called the "fear gauge" by market participants. At the end of February, this gauge reached its highest level since August 2015, reflecting the meaningfully higher volatility of stock prices in the US. In one week, this index rose by 22%, the strongest weekly rise since October 2008.

In other words, one can measure the degree of uncertainty and nervousness of investors by observing the volatility index. And it is clear that after having been relatively relaxed about the Coronavirus since the beginning of the year, savers across the world have started to doubt whether the disease could be contained and whether the global economy could withstand it rapid spread beyond the Chinese borders. A significant number of them decided to lighten up on their equity exposure as a result, giving rise to what is now officially labelled as a market correction, as several major stock market indices dropped by more than 10% from their recent highs.

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