“The volatility comes back to the financial markets”. “The markets are prey to volatility”. “Here is volatility again.” You can read these, and variations of these, titles in the financial chronicles. The fact is that it is necessary to intervene when this happens. However, the volatility for most risk-taker operators is also an investment asset, but it must be treated with extreme caution.
What’s volatility
The term volatility is a measure of the amount of the increase or decrease of the value of an investment. The larger and more frequent the variation of the price of an asset is, the more it is considered volatile.
The volatility is typically measured by the standard deviation, which gives the oscillation of the price with respect to its average value in a certain period of time. A higher value of this indicator indicates high volatility.
The volatility of an investment is linked to uncertainty for future returns. The prices of stocks, for example, are much more volatile than those of bonds. This is due to the fact that the performance of a stock depends on the results of the company, which are difficult to foresee, while bonds offer more certain future payments.
Volatility is not a negative thing. If an investor is ready to accept the possibility of a fluctuation in the value of his investment in the short period, then stocks guarantee a long-term yield greater than bonds. Moreover, strong downside variations usually create exceptional entry points on quality stocks at very affordable prices.
When you talk about volatility you must also bring to mind the concept of implied volatility, which is an estimate of the prices in the next future, and it is often used to set the price of options contracts.
Volatility as an investment asset
The investment strategies on volatility treat this element as an asset class.
The investment by specialized funds and expert operators is made through the use of put and call options on a pool of underlying assets. The options are derivatives, which are financial instruments whose value is based on the price of the underlying assets. You can think of an option as a contract you buy by paying a premium price. A high implied volatility results in options with higher premiums. The contract allows you to exercise the right to buy (call option) or to sell (put option) the underlying asset at a pre-fixed price (strike price) and within a certain expiration date, the last day that an options or futures contract is valid.
The investor will actually buy or sell only if he will benefit from this action, that is only if within the expiration date the market value of the stock is higher or lower than the strike price. The investor has no obligation to buy or sell if not convenient, but the premium price is not recoverable.