Standard deviation is a statistical term that measures the amount of variability or dispersion around an average. Generally speaking, dispersion is the difference between the actual value and the average value. The larger this dispersion or variability is, the higher the standard deviation. The smaller this dispersion or variability is, the lower the standard deviation. Price moves greater than the Standard deviation show above average strength or weakness.
Standard deviation values are dependent on the price of the under security. Securities with high prices will have higher standard deviation values than securities with low prices. These higher values are not a reflection of higher volatility, but rather a reflection of the actual price. Standard deviation values are shown in terms that relate directly to the price of the underlying security. One would have to divide the standard deviation by the closing price to directly compare volatility for the two securities.
Types of volatility measures:
- Historical volatility
Historic volatility is the standard deviation of the change in price of a stock or other financial instrument relative to its historic price over a period of time. That sounds quite eloquent but for the average investor who does not command an intimate knowledge of statistics, the definition is most overwhelming.
- Volatility index (VIX)
Just as we can calculate a stock’s volatility, we can do so for an index such as the NSE or its exchange-traded fund equivalent. For many indices, a volatility index has been created and is commonly quoted in the financial media.
These volatility indices are a weighted average of the implied volatilities for several series of options (puts and calls). Many market participants and observers will use these indices as a gauge of market sentiment.
- Intraday volatility
This represents the market swings during the course of a trading day and is the most noticeable and readily available definition of volatility. Intraday volatility reflects the difference between the high and low on the day divided by the closing price of the day for the stock.
- Implied volatility
It is the current volatility of a stock and is estimated by its option price. When looking at an option to determine its implied volatility, there are five parts to take into account. These include the strike price, the expiration date, the current stock price and the stock dividends paid by the stock. Investors will then use an options pricing model, using these parts, to find the implied volatility. This calculation is often used to find an option’s value in the market. When options trading, investors will use this calculation when setting up combination strategies. These investment strategies are used to find expensive or cheaper options. It is important to note however, that each option on a stock can and will most likely have a different implied volatility because there different strike prices and expiration dates.
The bell curve above suggests that with reference to the mean (average) value that 68% of the data is clustered around mean within the 1st SD, in other words there is a 68% chance that the data lies within the 1st SD. This means, if we know stock mean and SD then we can pretty much make an ‘educated guess’ about the range within which stock is likely to trade over the selected time frame.
The first thing you need to identify before you initiate any trade is to identify the stop-loss (SL) price for the trade. As you know, the SL is a price point beyond which you will not take any further losses. For example, if you buy Nifty futures at 8300, you may identify 8200 as your stop-loss level; you will be risking 100 points on this particular trade. The moment Nifty falls below 8200, you exit the trade taking the loss. An effective method to identify a stop-loss price is by estimating the stock’s volatility. Volatility accounts for the daily ‘expected’ fluctuation in the stock price. The advantage with this approach is that the daily noise of the stock is factored in. Volatility stop is strategic as it allows us to place a stop at the price point which is outside the normal expected volatility of the stock.