Why market volatility is so low right now - and what you should know about it
January 9, 2023 (Investorideas.com Newswire) Among the many challenges that investors and traders had to face throughout 2022, volatility certainly stands out. A confluence of factors brought the rise of assets like crypto or stocks to a halt, and even safe havens such as bonds were not spared.
Coping with market volatility is not possible without understanding the basics of the market, and while that might seem complex at times, it is absolutely essential.
What is volatility?
Asset price volatility refers to the degree to which the price of an asset fluctuates over a given period of time. An asset is considered to be highly volatile if its price changes significantly over a short period, while an asset with low volatility has a more stable price.
According to experts we talked to at GFund Assets, an online brokerage offering its services to customers worldwide, volatility is one of the main factors leading to poor results among retail traders. That is why you should first and foremost understand the leading factors driving volatile price behavior, before you enter the markets.
Reasons behind current market volatility
There are endless reasons that can lead to a choppy price performance, that is true, but they all can be brought down to three main categories: uncertainty, liquidity, and hedging. These are interconnected and by understanding the relationship between them, traders can better anticipate periods of higher volatility, as well as periods of calmer market performance.
It all starts with uncertainty around several factors. Taking the current framework as an example, investors and traders are worried about where the global economy might be headed over the next couple of quarters. A recession, slow economic growth, or continued expansion? These are still unanswered questions that will determine the performance of major asset classes in the near and far future.
On top of economic uncertainty, traders are also focused on monetary policy changes. Inflation is high and almost all assets are sensitive to interest rate changes. Brokers like GFund Assets cover FX, stocks, crypto, and commodities, enabling a great degree of diversification, but traders need to know how valuations might fluctuate when central banks shift policy from one month to another.
The second major reason driving volatility is liquidity. A liquid asset means there are many buyers and sellers at any given price. When that happens, valuations have a smooth performance, with no sharp retracements or spikes.
As a result of the above-mentioned uncertainties, institutional investors are not keen to put capital in the markets, preferring to keep it in cash until the picture is clearer. Less liquidity leads to higher volatility, considering each time large orders need to be filled, prices have to move aggressively.
A third factor to discuss is hedging. Institutional investors have diversified portfolios, but most of the time, hold long exposure to stocks and bonds. When risk events occur, some of these assets can be under pressure, so they need to hedge that outcome.
There are several hedging strategies like short-selling index futures or buying put options. Basically, if stocks go down, investors lose on their portfolio but compensate for that loss with hedging. Increased demand for hedges acts as a self-fulfilling prophecy, putting downward pressure on valuations.
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