What Is Volatility Forecasting?

Volatility forecasting refers to the practice of investors attempting to gauge the amount of price movement by a specific security over time. The securities that are the most volatile are ones that move over a wide range of prices and do so often in a short period of time. There is inherent difficulty in volatility forecasting, since securities that are volatile also tend to be erratic, thus making predictions tricky. One way to forecast volatility is through the standard deviation method, which measures the difference between a security's daily prices over a certain time period and its average price over that same period.

Investors must grasp the concept of volatility before taking on the stock market. An investor wishing to get involved with a stock over a long period of time likely doesn't want to see it rise and fall erratically for the entire time it is held. Risk levels and volatility levels tend to move in proportion to each other. For those reasons, volatility forecasting is a skill that most investors should try to cultivate.

The essence of volatility means that any security that possesses it in great degree is a difficult one to assess on a daily basis. A volatile stock might have prices that bounce up and down almost at random. Investors often try and predict the timing of those rapid movements. Volatility forecasting is especially necessary for those investors who practice day trading, which often requires buying and selling securities in a matter of hours.

One method investors use to practice volatility forecasting is the standard deviation method. This requires taking the average of a security's price over a given time period. Once that is achieved, each day's price during that same period must be measured against that average. The difference between the daily price and the average price represents the daily deviation. Averaging up these deviation totals provides an amount that can be used as a basis for comparison for the volatility of different stocks.

Another simple way that a novice investor can do a bit of volatility forecasting on his own is to chart the price movement each day for the securities he wishes to study. If the chart shows lines that go up and down in a haphazard fashion, the volatility level for the security in question is significantly high. A steadier line on the chart signifies a security that is relatively stable. Projecting those charts into the future can give a decent estimate of future price movements.