# In finance, volatility most frequently refers to the standard deviation of the continuously compounded returns of a financial instrument within

a specific time horizon. It is used to quantify the risk of the financial instrument over the specified time period. Volatility is normally expressed in annualized terms, and it may either be an absolute number (\$5) or a fraction of the mean (5%).

Volatility terminology
Volatility as described here refers to the actual current volatility of a financial instrument for a specified period (for example 30 days or 90 days). It is the volatility of a financial instrument based on historical prices over the specified period with the last observation the most recent price. This phrase is used particularly when it is wished to distinguish between the actual current volatility of an instrument and
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actual historical volatility which refers to the volatility of a financial instrument over a specified period but with the last observation on a date in the past actual future volatility which refers to the volatility of a financial instrument over a specified period starting at the current time and ending at a future date (normally the expiry date of an option) historical implied volatility which refers to the implied volatility observed from historical prices of the financial instrument (normally options) current implied volatility which refers to the implied volatility observed from current prices of the financial instrument future implied volatility which refers to the implied volatility observed from future prices of the financial instrument

For a financial instrument whose price follows a Gaussianrandom walk, or Wiener process, the width of the distribution increases as time increases. This is because there is an increasing probability that the instrument's price will be farther away from the initial price as time increases. However, rather than increase linearly, the volatility increases with the square-root of time as time increases, because some fluctuations are expected to cancel each other out, so the most likely deviation after twice the time will not be twice the distance from zero. Since observed price changes do not follow Gaussian distributions, others such as the Lévy distribution are often used.[1] These can capture attributes such as "fat tails".

Volatility for market players
When investing directly in a security, volatility is often viewed as a negative in that it represents uncertainty and risk. However, with other investing strategies, volatility is often desirable. For example, if an investor is short on the peaks, and long on the lows of a security, the profit will be greatest when volatility is highest.

Periods when prices fall quickly (a crash) are often followed by prices going down even more. is more difficult to say. This is because when calculating standard deviation (or variance). or the opposite. a lower volatility stock may have an expected (average) return of 7%. extreme movements do not appear 'out of nowhere'. Two instruments with different volatilities may have the same expected return. Volatility is a poor measure of risk. Mathematical definition . "it is only a good measure of risk if you feel that being rich then being poor is the same as being poor then rich". through the use of derivative securities such as options and variance swaps. or 95%). And an increase in volatility does not always presage a further increase²the volatility may simply go back down again. This would indicate returns from approximately -3% to 17% most of the time (19 times out of 20. while during other times they might not seem to move at all. it is also possible to trade volatility directly. a time when prices rise quickly (a bubble) may often be followed by prices going up even more. These estimates assume a normal distribution. in reality stocks are found to be leptokurtotic. and amongst the models are Bruno Dupire'sLocal Volatility. all differences are squared. whether such large movements have the same direction. during some periods prices go up and down quickly. That is. 'doldrums' can last for a long time as well. would indicate returns from approximately -33% to 47% most of the time (19 times out of 20. or going down by an unusual amount. and the increasingly popular Heston model of Stochastic Volatility. This is termed autoregressive conditional heteroskedasticity. so that negative and positive differences are combined into one quantity. or going up by an unusual amount.[2] It's common knowledge that types of assets experience periods of high and low volatility. they're presaged by larger movements than usual.In today's markets. Also. as explained by Peter Carr. Volatility over time Although the Black Scholes equation assumes predictable constant volatility. Of course. For example. merely their dispersion. Most typically. with the same expected return of 7% but with annual volatility of 20%. A higher volatility stock. Poisson Process where volatility jumps to new levels with a predictable frequency. but the instrument with higher volatility will have larger swings in values over a given period of time. Volatility versus direction Volatility does not measure the direction of price changes. See Volatility arbitrage. with annual volatility of 5%. The converse behavior. none of these are observed in real markets. or 95%).

Suppose you notice that a market price index. or Wiener process. more generally. Then. 19 April 1997. which has a . if the daily logarithmic returns of a stock have a standard deviation of time period of returns is P. if SD = 0. These formulas are accurate extrapolations of a random walk.7. who looked at cotton prices and found that they followed a Lévy alpha-stable distribution with = 1. This was discovered by Benoît Mandelbrot. T = 1/12 of a year) would be The formula used above to convert returns or volatility measures from one time period to another assume a particular underlying model or process. (See New Scientist. Some use the Lévy stability exponent to extrapolate natural processes: If = 2 you get the Wiener process scaling relation. the annualized volatility is SD and the A common assumption is that P = 1/252 (there are 252 trading days in any given year). However.. whose steps have finite variance. indexes and so on.01 the annualized volatility is The monthly volatility (i. but some people believe < 2 for financial activities such as stocks. for natural stochastic processes.e.) Crude volatility estimation Using a simplification of the formulas above it is possible to estimate annualized volatility based solely on approximate observations.The annualized volatility returns. The generalized volatility is the standard deviation of the instrument's yearly logarithmic for time horizon T in years is expressed as: T Therefore. the precise relationship between volatility measures for different time periods is more complicated.

Of course.000. Assuming that the market index daily changes are normally distributed with mean zero and standard deviation . has moved about 100 points a day. The rationale for this is that 16 is the square root of 256.798 . the average magnitude of the observations is merely an approximation of the standard deviation of the market index. multiply by 16 to get 16% as the annual volatility. . up or down. that is. the expected value of the magnitude of the observations is ¥(2/ ) = 0. for many days. on average. This would constitute a 1% daily movement. which is approximately the number of trading days in a year (252). you can use the "rule of 16". This also uses the fact that the standard deviation of the sum of n independent variables (with equal standard deviations) is ¥n times the standard deviation of the individual variables. Some people use the formula: for a rough estimate.current value near 10. The net effect is that this crude approach overestimates the true volatility by about 25%. Estimate of compound annual growth rate (CAGR) Consider the Taylor series: Taking only the first two terms one has: Realistically. so this formula tends to be over-optimistic. most financial assets have negative skewness and leptokurtosis. where k is an empirical factor (typically five to ten). To annualize this.