Definition of Volatility in Finance:
In the world of trading, volatility is most commonly known as the amount of risk or uncertainty a security has based on changes in the security’s value.
What this means is, securities with high volatility are deemed “risky,” and securities with low volatility are deemed “safe.” This is primarily because low volatility securities don’t move as much as high volatility securities. There is less opportunity to lose money in a low volatility security due to wild price swings.
For example, if a stock hardly moves, it will have low volatility. On the other hand, if a stock has massive intraday moves, it will have increased volatility. If a stock is moving all over the place, often by 5% every day, the volatility will be enormous because of the extreme and unpredictable price swings. Market participants and market makers will likely want or have to hedge against these swings, and will be willing to shell out big bucks to do it. This subsequently drives up the price of the call options and put options.
Definition of Volatility in Options Trading:
The other common reference of “volatility” is in correlation to options pricing. In this definition, the meaning of volatility is the same but it refers to how cheap or expensive options on an underlying asset are.
Breaking Volatility Down
Simply put, volatility is exactly what it sounds like. In basic chemistry, if an element is volatile, it means it has a tendency to dramatically explode or evaporate because of weak molecular bonds. Pure sodium is a great example of an element with a high level of volatility. When it’s placed in something as simple as water, it causes an explosive reaction. However, when pure lead is placed in water, there is no dramatic chemical reaction. This is because lead is an element with a lower level of volatility.
The same concept applies to stocks.
