Understand Volatility
The most important parameter “Volatility” in the trading and
investment is often neglected by the traders. Only few statistical indicators
in the technical study consider the volatility as a key parameter in their
combination. Volatility also informs well in advance how the price is going to
behave in the near future. The dynamic price action of a financial instrument
whether it is a stock or currency or future always follows the internal
volatility in it.
The most appropriate and common definition I have derived for the
volatility is, “The annualized standard deviation of the price change”. The
standard deviation is a statistical calculation and most beautiful work
available in the branch of statistics.
At this point you may ask “How the volatility is going to
bother you?” Volatility in the financial mathematics is often treated as a
discouraging word. The financial translation of the word volatility says, “The
risk associated in the investment over a particular time”. When the analyst
in the business channel broadcast the news that market is currently volatile we
all anticipate something risky. The most general view the trader concludes that
“doing the business in the stock or in the financial instrument will increase
the risk of failure”. However the fact and the truth reveals that none of those
broadcasters have an appropriate scale to measure and inform us a correct
number on volatility before pressing the panic button.
Volatility is classically defined as a powerful untrained horse
which has all capacity to win the race if trained properly. Same time the
powerful horse has the capacity to kill his rider if not guided properly.
Definition of volatility - “it is the risk associated with the
price at a particular time”
Mathematical definition - “the annualized standard deviation of
the price change”
How to calculate volatility?
1. Estimating the volatility based on the periodic return:
In this method we need to calculate the periodic return of the price change and
calculate the daily volatility using the standard deviation formula. Below are
the steps involved in calculating the daily volatility based on the periodic
return.
I have calculated volatility for NIFTY on 02/02/2016 based on past 1 month data from 01/01/2016 till 02/02/2016. We would compare our manually calculated volatility with NSE NIFTY volatility at the end.
Step 1 :- Find the periodic return by using LN (current price/previous
price) as shown in image below
Continue to calculate log returns till the end
Step 2 :- Take periodic return square as shown below
Continue to calculate log returns till the end as shown below
Step 3:- Arithmetic average of the
periodic return
Step 4 :- Arithmetic average of the square periodic return
Step 5 :- Variance= Arithmetic average of
the square periodic return- (Arithmetic average of the periodic return)2
Step 6 :- Daily volatility = Square root of (Variance)
Step 7 :- Annual volatility = daily volatility X square root of (Number
of days in a year)
Final Calculation as shown below
NSE NIFTY Volatility shown in below image as on 02/02/2016
If you observe our calculation for Daily Volatility i.e 1.044 vis-a-vis Nifty Daily volatility i.e 1.05 , it is almost similar and
Manually Historical Volatility calculated i.e 19.96 vis-a-vis NIFTY annualised volatility i.e 20 is the same , if we round off 19.96 to nearest value.
You may also download the excel sheet below for your future reference
Help other by sharing the post if you like
You should also read
How to select mutual funds for portfolio ?
How much insurance do I need ?
Mutual Funds versus ULIP
How to select mutual funds for portfolio ?
How much insurance do I need ?
Mutual Funds versus ULIP
Equities related article :
What is Power of Attorney in Online Trading?
Futures & Options related article :
