What’s Stock Market Volatility?

When the stock market goes up one day, and then goes down for the next five, then up again, and then down again, that’s what you call stock market volatility.

In layman’s terms, volatility is like car insurance premiums that go up along with the likelihood of risky situations, such as if you have a poor driving record or if you keep the car in a high-theft area.

Some cynics say volatility is a polite way of referring to investors’ nervousness. Investors may think volatility indicates a problem. But many analysts believe that increased volatility can indicate a rebound.

Volatility is measured by the Chicago Board of Options Exchange (CBOE), primarily through the CBOE Volatility Index (VIX) and, to a lesser extent, the CBOE Nasdaq Volatility Index (VXN) for technology stocks. The VIX tracks the speed of stocks’ price movements in the S&P 100; the VXN tracks it in Nasdaq 100 stocks. Both indices take a weighted average of the estimated volatility of eight stocks on a particular index. Both are calculated every 60 seconds over the CBOE’s trading day, which means it records a great deal of fluctuation.

Seasoned traders who monitor the markets closely usually buy stocks and index options when the VIX is high. When the VIX is low, it usually indicates that investors believe the market will head higher. This, in turn, can trigger a market selloff, as speculators try to unload their holdings at premium prices.

Historical data has shown that wild market movements precede a change in the market’s direction. A high VIX appears just before a market rally, and a low VIX usually augurs a slide.

Bearish types argue, however, that any value to the VIX’s past behavior ended on September 11. They say the market is up against too many things, including the economy, wary investors, and ongoing fear of terrorist attacks. Others blame volatility on 24/7 financial news on cable and the Internet, since people can watch the market move in front of their eyes.

So what’s an investor to do? For starters, remember that success in the market does not depend on predicting the future—predictions only measure the short term. Volatility is more dependent on mass hysteria—fear and greed—than on underlying economic or financial events. Those are not reliable emotions on which to base long-term investment decisions.

All Indices are unmanaged and are not available for direct investment by the public. Past performance is not indicative of future results.

© Copyright 2008 Commonwealth Financial Network