Stock Market Volatility & Learning
- The stock market has exhibited volatility since its inception. As investors became more sophisticated with the development of computer technology, it was soon discovered that studying volatility could give a new perspective on the market not seen before. To capitalize on this development, in 1990 the Chicago Board Options Exchange (CBOE) created what is regarded as the most effective way to measure volatility: the Volatility Index.
- The Volatility Index is commonly referred to as the VIX. "VIX" is the ticker symbol for the Volatility Index. The VIX is most effectively viewed on a chart. The VIX has no intrinsic value---it is not backed by a security of any type. Rather, it represents a weighted average of options contracts on the S&P 500. Options contracts are bought and sold by investors who wish to bet on price movements during specific periods of time.
To measure the volatility of an individual stock, the accepted method is referred to as "beta." The beta of a stock represents the correlation of its price changes to the market benchmark, the S&P 500. Beta was developed as a component of the Capital Asset Pricing Model (CAPM), a method designed to assess the intrinsic value of a stock. The CAPM was created by economists Jack Treynor, William Sharpe, John Lintner and Jan Mossin. They won the Nobel Prize in Economics for the contributions the CAPM made to the field of finance.
Features of the VIX
- In order to use the VIX, type "VIX" as the ticker symbol into any website that charts stocks. Stockcharts.com offers free effective charting tools. The higher the value of the VIX, the more volatile the market. A more volatile market is a riskier market. As uncertainty in the market increases, the VIX increases. It is generally accepted that the VIX has a negative correlation to major indexes like the DJIA and the S&P 500. As the values of the DJIA and S&P 500 increase, the VIX generally loses value. By recognizing changes in volatility using the VIX, it is possible to obtain a better understanding of the risk involved in participating in the market.
Features of Beta
- Beta is typically published as a number between 0 and 5. A stock with a beta of 0 has no correlation to the S&P 500. A stock with a beta of 1 is positively correlated with the S&P 500, and is considered to be equally as risky as the S&P 500. A stock with a beta of 2 would be considered twice as risky as the S&P 500, but not necessarily positively correlated. The beta of any stock can be found published on many free websites, such as Yahoo! Finance. There is also a formula for calculating beta (see Resources).
If you wish to find riskier stocks to research, beta is an effective way to filter your choices. In the analysis of the riskiness associated with a particular stock, beta gives a clear and readily comparable metric to use, no matter what stock you choose.
- The value of the VIX changes daily, along with the value of the DJIA and S&P 500. Though the VIX can be used to assess risk in the market, it merely represents a snapshot of what investors perceive market risk to be at any given moment. It is not considered wise to use only the VIX method of forecasting and investing, as other tools must be used as well.
Just like the VIX, beta is a snapshot of risk at a given moment. Always use beta in conjunction with other tools of analysis to make a truly informed investment decision.