How to Best Measure Stock Price Volatility

Author: George Davis

Measuring stock price volatility

When trading securities for investments, traders pay close attention to historical volatility to determine the level of risk associated with the investment. Typically, the more volatile the stock, the higher the risk, but it cuts both ways. In terms of trading, it depends on the investor’s mindset to invest in high volatile stock.

Some like to play it safe, while others enjoy the thrill of investing in a stock that fluctuates widely.
There are numerous ways to measure stock price volatility, and every trader has a favorite. Moreover, understanding the concept of volatility and how it is determined is crucial for successful investing. In this article, we will share different ways to measure stock price volatility, so you can pick your favorite.

3 Ways to Measure Stock Price Volatility

Measuring stock price volatility is easy if you are good with numbers. However, number crunching is the primary requirement of being a stock investor. Typically, there are 3 ways to measure stock price volatility:

1. Standard Deviation
2. Maximum Drawdown
3. Beta

1. Standard Deviation

The most popular way of measuring stock price volatility is “Standard Deviation.” This measure of stock price volatility reflects the average amount of a stock price that differed from the mean over a specific period. Chartists use Bollinger bands to calculate the standard deviation. The Bollinger band comprises three lines, and it reflects the Simple Moving Average (SMA). The SMA is the flattened version of stock price history, but it has a slow response to change. The bands on the outer side of the SMA reflect adjustments to standard deviation. Although there are other ways to measure stock price volatility, the standard deviation is widely accepted, and when traders say volatility, they mean standard deviation.

2. Maximum Drawdown

Another method of measuring stock price volatility is through maximum drawdown. Maximum drawdown is the measure of the maximum fall between the highest peak and the lowest trough. In other situations, options (financial instruments) can be used to ensure an investment will not cause an unexpected loss.

Many successful growth investors like William J. O’Neil look for stocks with a positive volatility trend, and the maximum drawdown methods help highlight such stocks. The idea behind this strategy is to look for stocks that have a high uptrend but remain stagnant when the stock market faces a downtrend. Stocks that maintain a stagnant position during a downtrend are considered winner stocks because people like to stick to them despite the downfall in the overall stock market.

3. Beta

Beta is the measure of a security’s volatility relative to the broader stock market. If Beta is 1, it means the stock in question follows the stock market’s direction. In the same way, relatively safe securities have a beta value lower than 1. However, stocks in rapidly changing markets such as technology have a Beta of more than 1, indicating highly volatile stocks. Lastly, if the Beta is 0, the underlying security has no market-related volatility.

Concluding Thoughts

Understanding stock price volatility is crucial to becoming successful in the stock market because unless you learn to play with high-risk stocks, you won’t achieve desired growth. Although volatile stocks are riskier, they offer a greater return for money. Investors looking to fire up their game and double their investments quickly prefer to buy volatile stocks. However, if you know how to measure stock price volatility, it becomes easier to invest in highly volatile stocks.

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