Measuring Volatility by Jean-Olivier Fraisse
Are financial markets becoming more and more volatile? Can they still attract the small investor, even with such impressive fluctuations in daily prices? Is program trading a source of additional volatility? While the media emphasize the wide swings that periodically occur in the financial markets, most academic studies have concluded that recent price volatility is little changed compared with that of previous years. Why the confusion? The media look at absolute price changes, while academic studies correctly assess volatility through the percentage change in daily prices or some similar price-relative measure.
Volatility is the tendency of a security price or return to vary over time: The higher the volatility, the larger the potential price move in the security within a given amount of time. Periods of low volatility, or consolidation periods, may be followed by large price moves. Volatility is also a key variable in option pricing. Thus, it is essential for investors to be aware of a security's current level and historical range of volatility.
Measuring volatility is more of an art than it is a science. Estimates depend on the period on which they are based as well as on the estimator — the estimating formula — used. While statistics tell us that the longer the estimation period, the more reliable the estimate, a relatively short period closer to the investment decision will better reflect a security's recent price behavior. With respect to the estimator, volatility can be measured in many ways, which frequently yields contradictory results. Fortunately, the specific estimator being used is of little importance. What is important, however, is that the same estimator be used consistently through the entire analysis so that today's level of volatility can be effectively compared with past levels. The volatility estimates, issued by different data services, in particular, may be not be comparable.