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Dramatic spikes. Wild swings. Extreme uncertainty. We hear phrases like these whenever the stock market is in a heightened state of volatility. But what does that mean, and how does it impact the market?

 

This is volatility, unpacked.

 

In March of 2020, the coronavirus pandemic contributed to spikes in market volatility similar to the 2008 Global Financial Crisis. U.S. equity markets saw the largest single-day drop since 1987’s Black Monday – and global indices entered bear market territory, which is when the market falls more than 20% from its recent peak.

 

Volatility is a measurement of price movement, and it’s fundamental to how the stock market works. The price of a single asset – like a stock, option, or bond – can change millions of times a day. This perpetual fluctuation describes normal stock market conditions, and it’s driven by supply and demand. When demand to buy shares is high, the price goes up. And vice versa. Investors’ desire to buy or sell a company’s shares is typically influenced by things like earnings reports, perceived growth potential, economic trends and company news.

 

Volatility describes an asset’s potential to rise or fall from its current price. It is expressed as a percentage and measures the variability of returns – money made or lost – over a period of time. Assets with higher volatility are generally considered riskier. The more uncertainty about an asset’s value, the more its price fluctuates.

 

A state of heightened market volatility results from two key drivers. The first, anything that causes macro uncertainty, which makes it difficult for the market to value assets. And the second, a lack of liquidity. “Liquidity” refers to how easy it is to buy or sell an asset without affecting its market price. Not enough buyers means you have to sell at a lower price, and vice versa. There are two types of volatility: Realized and Implied. Realized volatility is how much an asset’s price has moved over a historical timeframe. Implied volatility is how much an asset’s price is expected to move in the future. Implied volatility is related to options, which give holders the right to buy or sell an asset for a certain price in the future.

 

Just like interest rates, volatility is quoted on an annualized basis, which means it’s converted into a yearly rate. This helps investors by making the volatility comparable over different time periods. To assess the level of risk and uncertainty in the market, investors commonly use a market-wide volatility gauge called the VIX. It indicates expectations of volatility over the next month – based on the prices of options on the S&P 500 Index.

 

When the VIX reaches high levels of uncertainty, fewer investors willing to trade. Liquidity drops, volatility rises even more, and a negative feedback loop is created, making it very hard to trade.

 

The VIX recorded the three biggest volatility spikes in 1987, 2008 and 2020 where the negative feedback loop and reduced investor holdings caused a bear market each time.

 

But heightened volatility can also hit bull markets. During the 1900s dot-com boom, volatility rose alongside stock prices. The growth expectations placed on the exciting but untested internet technology also gave rise to increased uncertainty – especially as the bubble grew unsustainably.

 

What goes up, eventually comes back down. After a volatility spike, at some point levels do find stability, situations resolve, market shocks subside, and people gain a better understanding of the economic environment.

 

Dramatic spikes. Wild swings. Extreme uncertainty. These words are often used to describe a heightened state of volatility, like the trading environments in 1987, 2008 and 2020. But what does volatility really mean?

The material contained herein is intended as a general market and/or economic commentary and is not intended to constitute financial or investment advice. Any views or opinions expressed herein are solely those of the speakers and do not reflect the views of and opinions of JPMorgan Chase. This information in no way constitutes JPMorgan Chase research and should not be treated as such. Further, the views expressed herein may differ from that contained in JPMorgan Chase research reports. The information herein has been obtained from sources deemed to be reliable, but JPMorgan Chase makes no representation or warranty as to its accuracy or completeness.