Lucinda has taught business and information technology and has a PhD in Education.
In this lesson, you will learn about price volatility in the stock market. We'll go over how to calculate price volatility and how to interpret that calculation to help you with investment opportunities.
Price Volatility Defined
Sarah is interested in investing in the stock market. She is a little leery since she has heard so much about something called price volatility. She wants to make sure she understands what price volatility is before she makes her decision. Let's help Sarah make sense of price volatility.
Price volatility simply means the degree of change in the price of a stock over time. Some investment opportunities have a high degree of change, or high price volatility, and some have a low degree of change, or low price volatility.
It is common that investment opportunities with a high price volatility can mean a higher return on investment (ROI), meaning you can make more money faster than investing in low price volatility opportunities. However, the higher the volatility, the riskier the investment tends to be.
When Sarah is evaluating the price volatility of a stock, she needs to consider what will work in her portfolio. If she is younger, she can take more chances and invest in stocks with a higher volatility, which could give her higher returns over time. If she is older or uncomfortable taking risks, she may want to invest in stocks like Newton Appliances that do not have as high a volatility.
To help Sarah out, we will show her how to calculate historical volatility. Historical volatility is the calculation of price volatility based on the past history of a stock's performance.
Sarah is thinking about investing in Newton Appliances (fictitious company, not really on any stock exchange). She knows that she needs to see how the stock has done over time, so she researchers the company's stock prices over the last year and makes a list of the closing prices of the stock at the end of each month. With this information, Sarah can calculate the price volatility for her stock using a series of formulas:
Formulas for calculating price volatility
However, Sarah is not a math whiz and decides she would rather put her data into Excel and let the program do her math for her. That way she knows it was done correctly.
First she needs to calculate the percentage of change from one month to the next by using Excel's LN function The LN function calculates the natural logarithm. The natural logarithm is a mathematical way of equalizing a set of numbers so that it doesn't matter if the number is positive or negative. The LN function divides one month's price by the previous month's price. The formula looks like this: =LN(B2/B3) and produces this result:
Calculation of the natural logarithm for Newton Appliances
This information will help Sarah calculate the standard deviation. Standard deviation is the amount of variation in a set of data. Standard deviation assumes distribution is normal and will produce what is known as a bell curve, where most of the data (68%) will fall in the middle with equal highs and lows on either side.
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Using Excel's standard deviation function (STDEVA) and the price data, Sarah creates the formula =STDEVA(D3:D14) and gets the value 0.005357393, or .54%.
Now that she knows the standard deviation, she finishes the calculation to find price volatility by multiplying the standard deviation times the square root of 252. 252 are the number of days in a year that stocks can actually change in price.
She can use the Excel square root function (SQRT) to calculate the square root of 252. The square root of a number is a value that, when multiplied by itself, gives the number. So 2 is the square root of 4 because 2 times 2 equals 4.
She can actually do the whole process in one formula, which would actually look like this:
She winds up with a volatility value of 0.085045976, or 8.5%. What does this mean for Sarah? How does knowing that number help her?
With a price volatility of 8.5% and a standard deviation of .54%, Sarah can expect that 68% of the time, the Newton Appliances stock would fall within a range of 7.96% and 9.04% (8.5% +/- 0.5%). Meaning the stock price will likely change roughly by only 8-9% over time. This means the stock is not very volatile.
Now, this is only one measure for stock volatility, and it assumes that prices are distributed normally, with a bell curve. It is possible that there are stocks whose prices are not distributed normally, so this formula and evaluation may not be accurate. Sarah may have to look at other indicators, such as changes in the industry that may be affecting stock prices, but that is a discussion for another lesson.
In this lesson, we helped Sarah calculate the price volatility for her Newton Appliances stock. We learned that price volatility is the amount of change in the price of a stock. We learned investors use this information to determine how risky an investment might be. The general rule is that the more volatile, or the more a stock price changes, the riskier it may be. However, it may also result in a higher return on the investment.
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