Volatility Spikes Explained

Volatility measures how much the price of a stock, bond, or other financial security fluctuates over time. When the price of a security experiences big, sudden swings up and down, we say it has high volatility or that volatility has “spiked.”

Periods of elevated volatility can make investors nervous, especially if they don’t understand what’s causing the turbulence.

In this article, we’ll explain the basics of volatility and what causes it to spike. With some background knowledge, you’ll be able to ride out volatility spikes instead of making rash investing decisions.

What is Volatility?

Volatility is a statistical measure of the dispersion of returns for a given financial instrument. In layperson’s terms, this dispersion represents how much and how quickly the price bounces up and down.

Some securities, like stocks, tend to be more volatile. Their prices regularly make significant moves up and down. Other assets, like government bonds, have lower volatility. Their prices stay relatively stable over shorter periods.

Volatility also changes over time, even for the same security. Sometimes, stocks swing wildly from week to week; other times, they barely budge.

Periods of high volatility indicate lots of uncertainty in the market, where prices are unstable. Periods of low volatility indicate the opposite—more predictability and stability.

Common Causes of Volatility Spikes

Volatility doesn’t spike randomly. There are almost always clear events or factors driving an increase. Some of the most common causes include:

Geopolitical Events: Wars, elections, unrest, and trade disputes can all cause concerns about how global affairs impact markets. The uncertainty spikes volatility.

Economic News: Data on GDP, jobs, manufacturing, inflation, and other key economic indicators can move markets if the numbers come in far above or below expectations.

Earnings Announcements: When major public companies announce quarterly earnings, the results vs expectations and future guidance they provide can lead to big stock moves. Even expectations of upcoming announcements can increase volatility.

Interest Rate Changes: When central banks raise or lower interest rates, it impacts valuations across markets. Bond yields, stock earnings yields, mortgage rates, and more are affected.

Mergers and Acquisitions: When one company buys or combines with another, it causes the stock prices of both companies to fluctuate as details emerge.

Sector Developments: News that specifically impacts a particular sector, such as tech, energy, or real estate, can cause volatility as traders reposition.

Liquidity Issues: Thin trading volume can exaggerate price moves when there are more buyers than sellers or vice versa. Lack of liquidity increases volatility.

High-Profile Scandals: When large companies are involved in major scandals, such as fraud, data breaches, or misconduct, they shake up their stock price and broader market sentiment.

This is not a complete list, but covers many recurring drivers behind volatility spikes. The key is that volatility rises for each event because the outcome is uncertain.

How Long Do Volatility Spikes Last?

There is no set duration for volatility spikes. Some may last a day or two, while others persist for many months. A lot depends on the initial trigger and how long it takes for some resolution to occur.

For example, suppose an earnings announcement from a company causes a spike. In that case, the volatility may dissipate within a week as analysts and investors have time to digest the results. The uncertainty is resolved relatively quickly in this case.

On the other hand, if a spike is due to an outbreak of war or a global viral pandemic, the volatility may continue for many months. The ultimate impacts are unclear, so markets remain on edge.

Other factors can also prolong volatility spikes:

• Domino Effect - Sometimes, the initial volatility triggers cascade impacts into other markets and asset classes, propagating the uncertainty.
• Worried Sentiment - Once volatility spikes, it can spark fear and anxiety among investors. This emotion alone can exacerbate selling activity and price swings.
• Computerized Trading - Algorithmic and high-frequency trading strategies can detect volatility and initiate more buy/sell orders, further boosting volatility.

The more complex and far-reaching the initial volatility trigger, the longer the volatility spike is likely to last. But there are no guarantees, which is part of what makes volatility unpredictable!

Are Volatility Spikes Healthy?

Volatility spikes are often portrayed negatively in financial media, but are they necessarily bad? The answer depends on your perspective.

On the one hand, volatility spikes present an opportunity for short-term traders seeking to profit from quick price movements. The excessive price swings allow savvy traders to buy on dips and sell into rips if they time it right.

However, volatility spikes can displease long-term investors looking for smoother trading. The increased risk and uncertainty force portfolio rebalancing and asset allocation changes frequently, making “set and forget” investing more difficult.

For retirees and others relying on current income from their investments, volatility spikes also create problems. As principal values fluctuate rapidly, it becomes harder to withdraw steady income from the portfolio.

Excessive volatility can even negatively impact the broader economy. Companies may hold off on Initial Public Offerings (IPOs), investors could get spooked and pull out of markets, and consumer uncertainty may curtail spending.

Moderately increasing volatility, however, can be a healthy sign of properly functioning markets. Some back-and-forth is necessary for asset prices to find equilibrium levels where buyers and sellers agree on value.

Overall, volatility spikes are usually not dangerous on their own merits. They become problematic if they are too frequent or too severe or if systemic risk builds up while they are occurring.

Bottomline

Volatility spikes can be intimidating, but understanding what causes them and how long they tend to last helps remove some of our worries. While no one likes seeing their portfolio value temporarily decline, volatility also brings trading opportunities.

Traders who are educated about market volatility can often profit during periods of turbulence.

The next time you see a headline about a volatility spike, remember that it’s usually tied to a specific trigger event, like an earnings report or geopolitical news.

The price fluctuations likely won’t last forever. Stay calm, review your long-term investing strategy, and avoid rash decisions.

Volatility is part of the journey when participating in financial markets. Learning to anticipate it and adapt is the key to investment success.

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“When considering “CFDs” for trading and price predictions, remember that trading CFDs involves a significant risk and could result in capital loss. Past performance is not indicative of any future results. This information is provided for informative purposes only and should not be considered investment advice.”