Understand Market Volatility: A Practical Guide for Investors

What is volatility and why is it key to your investment?

Volatility is the continuous movement of prices experienced by financial assets such as stocks, indices, currencies, commodities, and cryptocurrencies. It involves price fluctuations that occur both in the short and long term, and is an inherent characteristic of markets that investors cannot avoid.

Although media often present volatility as synonymous with risk and uncertainty, the reality is different. For experienced investors, volatility is simply part of the game. The key is to understand that volatility represents both opportunities for profit and risks of loss, depending on how you manage it according to your strategy and risk tolerance.

In-depth definition: how volatility works

When we talk about what volatility is in technical terms, we refer to an asset’s tendency to fluctuate rapidly and significantly relative to its historical average. These changes are often driven by external factors such as economic events, political developments, shifts in market sentiment, and supply and demand variations.

Here’s the important part: volatility does not only imply price drops. It can also mean sudden increases. An asset with high volatility experiences sharp peaks and troughs over short periods, while one with low volatility maintains more gradual and stable changes.

The two main types of volatility you should know

Historical volatility: Calculated by analyzing past data to measure how an asset’s returns varied over a specific period. While useful as a reference, it’s important to remember that past results do not guarantee future performance.

Implied volatility: Measures market expectations of future volatility using the current prices of derivatives like options. It reflects market uncertainty and sentiment. When sentiment is bearish, it rises; when bullish, it falls. However, these indices only capture a snapshot of current sentiment.

There is also stochastic volatility (which changes unpredictably over time) and deterministic volatility (which remains stable or changes in a predictable manner).

What generates volatility in markets

Economic cycles are the main driver. During economic expansions with solid corporate profits and high consumer confidence, volatility tends to be low. But during contractions or recessions, investors become more cautious and volatility spikes.

The 2008 crisis and the COVID-19 pandemic are clear examples. When economic conditions deteriorate rapidly, investor confidence drops and markets suffer sharp declines.

Government decisions also matter. Regulatory decrees affect economic performance and immediately generate reactions in asset prices.

Macroeconomic data are important: inflation, consumption, GDP. Positive data boost confidence; negative data erode it.

At the microeconomic level, regulatory changes, unexpected news, natural disasters, or companies’ financial results generate volatility in specific stocks and sectors.

Volatility: different impact depending on your investment horizon

For long-term investors

Volatility is expected. During turbulence, the key is to stay calm and remember your goals. Don’t panic and sell everything. Markets are cyclical and tend to recover.

Volatile periods can be opportunities. If you have available liquidity, you can buy assets at reduced prices. But here’s the critical part: you need a robust emergency fund to avoid selling during downturns, and your portfolio should be well-diversified.

Consider rebalancing periodically to maintain your desired asset allocation and your target risk level.

For short-term investors

These traders thrive on volatility. They capitalize on quick fluctuations to buy and sell over short periods, capturing gains from small price movements.

Volatility also increases market liquidity, facilitating quick entries and exits. But be careful: predicting short-term price changes is difficult. Never invest more capital than you are willing to lose entirely.

Volatility vs. Risk: they are not the same

These terms are often confused, but they are different.

Volatility measures how much an asset’s price fluctuates over time, typically expressed as the standard deviation of returns.

Risk is the probability that your investment will not achieve the expected return; in other words, the chance of losing part or all of your capital.

A fundamental principle: risk and return are proportional. To assume more risk, you expect higher returns. This compensates for the possibility of losses.

How volatility is measured

Standard deviation: The most common method. Calculates how dispersed prices are around the average.

Beta: Compares an asset’s volatility (for example, Tesla stocks) against a market index (such as the S&P 500).

ATR (Average True Range): Measures the greatest distance between highs and lows of the current and previous day.

Volatility indices: Tools like the VIX measure market uncertainty based on S&P 500 options. A higher VIX suggests greater expected volatility. It is considered a “fear” indicator of the market.

Important: no method predicts future volatility with absolute accuracy. Use them as informed tools, aware of their limitations.

The most relevant volatility indices

VIX is the most famous, but there are others:

• VXN: For the Nasdaq-100 index
• VXD: For the Dow Jones Industrial Average
• RVX: For Russell 2000
• STOXX 50 VOLATILITY: For European markets
• Sector indices like VXGOG (technology sector) and VXXLE (energy sector)

These indices behave inversely to traditional stock indices. When they rise, they indicate instability; when they fall, confidence.

For investors, volatility indices are valuable because they reveal how the market perceives risk. If you expect increasing future volatility, you can adjust your portfolio proactively. They also help identify optimal moments to buy or sell according to your strategy.

Volatility by asset type

Stocks: Volatile due to multiple internal (financial results, management, new products) and external factors (politics, economy, technology, interest rates). Higher potential gains, but also higher risk of losses compared to bonds or deposits.

Forex: Highly volatile. The decentralized 24/7 currency market allows constant exchange rate fluctuations. Any global event has an immediate impact. It is more volatile than stocks or bonds.

Cryptocurrencies: Among the most volatile assets. Bitcoin, for example, went from less than $3,500 in December 2018 to nearly $20,000 at its peak. This extreme volatility is due to the speculative nature of the market and lack of regulation. It is considered a high-risk investment.

Investment strategies according to your profile

Every investor is unique. Your portfolio should reflect your available capital, risk aversion, and short- and long-term liquidity needs.

A retiree needing funds soon will prefer conservative, low-risk investments. A young investor with more time can accept higher volatility in pursuit of greater long-term gains.

Final reflection

Volatility is inherent to financial markets. It’s not something to avoid but to manage. It can be your ally if you understand how markets operate, recognize your personal strategy, calculate your capital needs over different timeframes, and clearly define your risk tolerance.

The next step is to analyze the historical, current, and projected volatility of the assets you are interested in (using volatility indices) to determine if they align with your expectations and goals.

Proper risk management related to volatility is what separates successful investors from those who lose money. Prepare yourself, diversify, and stay disciplined even when markets are turbulent.