Financial market volatility is the degree to which the price of an asset goes up or down in the global market.
Many investors in Nigeria are affected by the volatility in the global markets, because the stock & currency markets in Nigeria are also affected by the risk sentiment globally.
Volatility is always present in markets, if not there would be no price changes for you to trade on. However economic policies like central banks hiking interest rates, can spook investor sentiment, and cause the kind of panic behavior that results in higher volatility.
Activities of High Frequency Traders (HFTs) who sit in hedge funds, and use complex algorithm to trade large volumes of assets in seconds, can also cause turbulence in markets. All these and many other factors can spike volatility.
Some investors believe high volatility every now and then is good for the market. And some investors see volatile periods as an avenue to make more profit since prices swing wildly in both directions, you should also respect the risk involved.
How To Know When Market Volatility Is High?
1: The VIX (Volatility Index)
Investors use the VIX as a barometer, to determine the rate at which the S&P 500 Index will fluctuate within the next 30 days. You can use the VIX to analyze sentiments of investors, which would guide your trading decisions.
When the S&P500 index is losing points, investors hurriedly begin to buy Put Option Contracts, bestowing on them the right but not obligation, to sell their stake at the current market price, but at a future date.
This kind of behavior connotes fear, and the VIX index (aka fear index), is built on this market sentiment of fear.
If the VIX reading is between 0 and 15, it shows that the volatility is extremely low. If the index is between 15 and 25, it shows moderate volatility. However, a VIX reading of 30 and above, shows that volatility is now extremely high.
Three Notable Dates When VIX Closing Reading Was High:
2: Bollinger Bands
This is a technical analysis indicator used to measure the level of market volatility. Bollinger brands have three main bands, which are the central, upper, and lower bands.
The middle band is a moving average, and the upper & lower bands are 2 Standard deviations of that moving average.
With it, you would know whether an asset is overbought or oversold, and this would guide your trading decision.
On your trading chart, you can select Bollinger bands, and the3 bands superimpose themselves on top of your existing chart. When the bands are narrow and close to each other, it indicates low volatility, and when wide apart it indicates high volatility.
3: Average True Range (ATR)
ATR helps you measure the volatility of an asset by studying its price range within a time period.
Let’s take 14 days for example. The ATR will calculate the price difference between opening and closing prices, over a 14-day period. With this data it plots a graph which is displayed below your chart.
From the graph you easily see the peaks when ATR figure is high, and it means high volatility in the market. You also see the graph sloping down ward when ATR figure is low and this means low volatility.
Risks Investors Face During High Volatility
1: Interest Rates Changes Could Work Against You
The interest rate is the percentage a lender charges when you get a loan. It is also a reward for saving.
If you are a stock trader, note that volatility in interest rates could have an impact on the borrowing costs of companies, which results in a reduction in investment.
Read also:Why forex trading is risky for Nigerian retail investors
A reduction in investments would negatively affect earnings,and stock prices of a company in which you have shares, and this would make shares in your investment portfolio to lose value.
Volatility in interest rates can also have a significant effect on the forex market, because when interest rates in one country are higher than those in another, its currency will appreciate.
On the other hand, if interest rates in a particular country are lower than those in another, it leads to currency depreciationrelative to those currencies. However, this is when both economies are at par in terms of soundness.
Another area where interest rate volatility can affect you is ‘Carry trade’, where you borrow a currency that has a low interest rate, and use the funds to purchase another that has a higher interest rate. The aim is to earn profits from the difference in interest rates.
However, engaging in currency carry trade, comes with massive risks because central banks keep hiking interest rates globally to fight inflation.
Imagine you have a pending open currency derivative position where you borrowed USD (4.75% interest rate) to buy GBP (4% interest rate), you will lose money because you’re paying higher nightly interest to borrow.
Now even if you borrowed a currency with a lower interest rate to buy one with a higher interest rate, the central bank of the currency with a lower rate could suddenly hike interest rates and change the dynamics of your trade. You will then see yourself debited for interest rate differential. This is due to volatility.
Your bond portfolio could also lose value whenever there is volatility in interest rates. A hike in rates means your older bonds carrying lower rates, become unattractive should you want to sell them.
The collapse of Silicon Valley Bank (SVB) due to its exposure to Government Bonds is a classic example. During the pandemic, SVB had a lot of cash deposits because tech companies saw hikes in profit. It used this excess cash to buy government bonds.
After the pandemic, the Russia-Ukraine conflict started causing global inflation. Tech companies began to record lower profits and carryout layoffs. These tech companies would also start taking cash out of SVB.
The Federal Reserve would also hike interest rates to never seen before levels, in order to reign in soaring inflation. Faced with cash shortage, SVB decided to sell off its bond portfolio, but its market value had dropped because newer bonds carried higher interest rate payments.
News of SVB trying to offload its bond exposure got to the market, leading to a run on the bank as investors panicked and began to pull out huge deposits, leading to the bank’s collapse.
Those trading SVB shares are now at a dilemma as trading of SVB shares have been halted, pending when a buyer is found.
2: You Risk Paying Higher Spreads during High Volatility
High volatility can also lead to you paying a higher bid-ask spread during online trading. The spread is the difference between the Ask and Bid Price of an asset.
During high volatility periods, the bid/ask spread would widen because your broker would want to be compensated for risk taken, by selling to you at a higher price.
According to Akin from Nigerian broker research website Forex Trading Nigeria, widening of spreads by brokers is very common in forex markets, especially during events or news that could lead to high volatility, like interest rate decisions, or Central bank meetings.
Different brokers charge different spreads on the same GBP/USD or EUR/USD currency pairs for example, depending on how much risk they are willing to carry. Theyadjust the spread to reflect the current state of volatility in the market.
Today tension in Europe between Russia & Ukraine, China reopening its economy, drought & other natural disasters, all affect exchange rates thus spiking volatility.
If you trade commodities, you will also experience varying spread from your broker. Commodities are some of the most volatile asset classes in the market.
Oil and Gas are more volatile than say agricultural produce,because demand is high and consumers cannot substitute them. It is not easy to turn off your gas and start using coal.
‘Precious metals have really been performing but the energy space, I mean energy ETFs have really been significantly hit’ says Uchenna Minnis, Managing Partner at Howard Minnis asset management, when talking about the impact of the Russia Ukraine war on the energy market.
The conflict in Ukraine has indeed added to volatility of Oil and Gas, so this extra risk will translate into wider spreads. Without proper risk management, your positions may become loss making in the end.
3: You Risk False Breakouts
During trading, it would get to a point where the price of the asset you are dealing in breaks the support or resistance level to begin a new trend and this is a breakout.
However, the risk of false breakouts crops up when the price of an asset breaks the support or resistance point, but quickly falls back to its original trading range where it started.
The dangers of false breakouts mean your stop loss can be triggered and see your positions closed. High volatility leads to stop loss malfunction.
Every time your stop loss is triggered and you automatically closed out of the market, there are negative financial implications for you. To reenter the market, you pay new commissions and spread. It can also take an emotional toll on you.
Take Care of the Risks
Volatility is part of the financial market, and it will continue to happen as long as the activities that cause it keep recurring.
Understanding the risks of volatility before venturing into online trading & investing is very important, as it will help you prepare your mind and improve your trading skills so as to minimize your risks.
