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Tuesday, September 13, 2011

Is the recent stock market volatility unusual?

Before I answer that question, let me try and explain what volatility in the stock market really means. To the ordinary investor, volatility may mean sudden and unexpected changes in a stock’s price (or an index level).

But aren’t fluctuations in stock prices and index levels the norm rather than the exception? That’s an easier question to answer. Yes, stock prices and index levels do fluctuate all the time. But some times, the fluctuations are tolerable and ‘normal’. Those are periods of low volatility, which are conducive for trading and investments.

At other times, there are extraordinary and nerve-wracking fluctuations in stock prices and index levels that send traders and investors scurrying for cover. Such periods of high volatility increases risk and decreases returns.

For the mathematically inclined, volatility is a statistical measure of the uncertainty or risk associated with changes in a stock’s price (or an index level). It can be measured by using the standard deviation or variance (i.e. two standard deviations) of the returns from a stock or index.

A measure of the overall volatility of a stock’s return benchmarked against an index is called ‘Beta’. A Beta value of 1.0 means the stock’s return is the same as that of the index. In other words, if the index gains 100%, the stock will gain 100%. A Beta value of 1.5 means a stock will gain 50% more than the index during bull periods, but lose 50% more during bear periods; a value of 0.8 means the stock will gain 20% less than the index in a bull market, and lose 20% less in a bear market. The higher the Beta value, the more volatile the stock.

For the technically inclined, the Nifty VIX chart indicates the implied volatility (IV) of a basket of Nifty put and call options. A high VIX level (above 30) indicates high volatility; a low VIX value (below 20) indicates low volatility. Typically, when the VIX rises, the Nifty falls. The VIX can be used as a contra-indicator. Low values give an opportunity to sell, and high values provide opportunities to buy.

What causes high volatility? Unexpected changes - in interest rates (repo, reverse repo) or oil prices; a war or terrorist attack or earthquake; a change of government - can lead to wide fluctuations in stock prices and index levels.

What can small investors do? Understand this simple thumb-rule. Volatility declines when stock markets rise, and increases when stock markets fall. In a bear market – like now – high volatility is not unusual.

That is one reason why small investors may be better off staying away instead of trying to make a few bucks on counter-trend rallies; and avoid averaging-down during bear markets.

That was the long answer. The short answer to the question is: No.

Related Post

What is causing the volatility in the Sensex?

2 comments:

Anand said...

Subhankarji,

How would a big player earn money through shorts during such time ?
Would they take out quick profits or would they buy shorts for a longer time period?
Is it just a question of deeper pockets or is it a question of deeper insight. I ask this question because, if it is a question of insight, won't getting the right insight be sufficient for smaller investors as well to earn money through shorting ? I lost money trying to short when the market was falling owing to high volatality, just as you explained and so want to learn how to earn money during such periods. If it is just a question of deeper pockets (even if it requires deeper insight), I can simply bow out.

Thank you,
Anand

Subhankar said...

Good question, Anand.

Since I'm a small investor, and not a 'big player', I can share what I do.

Shorting isn't allowed in the cash market; i.e. you can't borrow a stock to sell it. So, I sell a stock that I already own. If the market goes against me, I don't lose money, but lose profits.

If the market goes with me, I wait for a support level to buy the stock back.

Shorting in the F&O market does require deep pockets. You get to play against Ramesh Damani and Rakesh Jhunjhunwala - not a game for the faint-hearted!