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Volatility – applying maths to the markets

06 Apr 2018

Volatility – applying maths to the marketsStatus – Turbulent markets

“Low volatility” is a hot topic in investor forums and the business press. But care is needed when mathematical expressions suddenly become fashionable. Imprecise definitions take hold quickly and are hard to get rid of.

Basically speaking, volatility measures the extent to which values deviate from a calculated mean. In a stock market context, it expresses how much prices vary over a given period of time. Stock market volatility is said to be low when prices are closely dispersed around the mean. In contrast, volatility is high when the mean and the prices of the shares traded differ substantially.

Professionals make the markets

How do such deviations in prices come about? Market participants have different expectations, and these are reflected in different prices. Doubts and uncertainties increase volatility, since investors are guided by their own personal ideas of what the future will bring.

Where these investors are professionals – i.e. institutional investors – this moves the markets. How do such medium- and long-term stock market movements and relatively isolated variations in prices fit together? “Professional traders depend on deviations in prices to enter and exit the market – for example by setting price limits”, explains Oliver Roth, Head of Specialist Floor Equities Trading at Oddo Seydler Bank. “Investors need a certain level of volatility in order to be able to invest in trends, especially where these are long-term.

One event, different outcomes

In other words, a high level of volatility triggers a variety of different actions by market participants. Some hedge their positions, while others buy and sell stocks. Increasingly, trades are made at different prices, which in turn attracts new market participants. Trading increases and market participants with different goals and preferences find attractive opportunities, and the market becomes more and more liquid and diverse as a result.

This environment offers traders good openings for entering and exiting the market, which also increases trading volumes. “Nevertheless, volatility isn’t actually mainly about trading volumes”, says Oliver Roth. “Large deviations in prices don’t affect the trading volumes for major investors’ portfolios in the short term”. Short-term in this context can be defined as a few days. “However, after four weeks or so we do see them impacting volumes for these market participants, too, as traders adapt their portfolios to market conditions”, says Roth.

Historically low implied volatility

Market volatility was at a historically low level in 2017. “Implied volatility indices – such as Deutsche Börse Group’s VSTOXX – recorded readings reaching below 11 per cent or so for the eurozone in 2017”, says Zubin Ramdarshan, Head of Derivatives Product R&D Equity and Index at the Eurex derivatives exchange. “Also noteworthy is that these historical lows are happening in a stock market that is hitting all-time highs. To this extent, the low VSTOXX also reflects the strong overall uptrend in the market, which is not seeing large reversals or downturns.” Still, not every trader and not every type of transaction was affected by this low volatility. As trader Oliver Roth says: “In the field where I work I can definitely see sufficient volatility in a rising market. In the short term there were always prices that deviated sufficiently from previous levels to let investors enter the market.”

Yet even if traders and markets adapt quickly to the new situation, the low level of volatility seen in 2017 remains unusual. Zubin Ramdarshan has the following explanation: “I do think there’s a level of volatility that can be regarded as ‘normal’, although this is a purely theoretical figure”, he says. “Use a different time frame and you’ll get a different mean. And yet I’d say that in recent decades typical – what I would call ‘normal’ – volatility on the European stock markets has been between 20 and 30 per cent, while in the US it has been between 15 and 25 per cent.”

A cluster of causes

Three volatility concepts

Historical volatility: This is the standard deviation of actual values from a calculated moving average; the latter can be modelled as a curve or a straight line.

Intraday volatility: This is calculated using the prices at the start and close of trading, along with daily peaks and troughs.

Implied volatility: This uses a sophisticated model applied to option prices to depict market expectations.

What, then, lies behind the extremely small fluctuations in prices seen last year? “I see the main drivers as two influential participants who are both relatively new to the market”, says Zubin Ramdarshan. “These are the central banks, which are purchasing bonds and other financial instruments on the one hand and ETFs on the other. Every market retracement in 2017 typically attracted further ETF inflows in a “buy-the-dip” strategy. So the upward trend in equities remained intact and realised volatility was consequently subdued.”

Finally, new trading styles based in some cases on innovative technologies are also preventing major price fluctuations. “Positions are now closed out earlier than they used to be – sales and purchases are made very quickly once a change in prices becomes apparent. This means that even major waves of stock market selling lasted just a few days in 2017”, he adds.

No cause for concern

“We haven’t seen any long-term downturns in market prices despite dramatic political events and elements of uncertainty”, is how Oliver Roth sums up the situation. “The markets are working – for both retail investors and professional traders. That’s good news.”

Volatility – indices

STOXX, a subsidiary of Deutsche Börse Group, offers a series of volatility indices. Implied volatility has become an important indicator on which to base products.

Zubin Ramdarshan echoes this assessment. “Contrary to popular opinion, extremely high levels of volatility are not inherently good for stock exchanges, which operate the markets.” He is convinced that “high levels of volatility only lead to higher levels of trading in the short term. In the medium term the opposite is true: extreme volatility frightens traders, who then close out their positions.”

This didn’t happen in 2017. For Ramdarshan, the glass is half-full, not half-empty: “Although trading volumes were slightly down at the end of the year, the level of open interest remained intact – and in fact increased.” As an exchange operator, Deutsche Börse cannot influence this directly, though it does facilitate and support liquid markets by providing an extremely broad-based, diversified order book. This gives as many clients as possible attractive opportunities to trade within a wide spectrum of products.

Go to Deutsche Börse Group’s Annual 2017 for this and more exciting articles.

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