In phases of market uncertainty, the daily highs and lows on the global stock exchanges are like a temperature curve. However, instead of measuring the situation on the markets according to their respective market rates, experienced investors take the markets’ volatility into account. In portfolio theory, volatility is considered a key figure for determining the risk of an investment. That’s because it measures the rate’s fluctuations around an average value and rises along with increasing uncertainty on the markets. Those who want to determine the risk of an investment or gain a feeling for market sentiment have to take a closer look at volatility – which is calculated by indices such as the VDAX-NEW, VSMI, VSTOXX or, available since the end of September, the EURO STOXX 50 Investable Volatility Index for the most important stock markets, for example the DAX, SMI and the leading European index EURO STOXX 50. If you want to use these indices for your investment decisions, however, you have to become familiar with the special characteristics of volatility.

Generally, we have to differentiate between a historical and a forecasted, or implied, volatility. Historical volatility is easy to calculate, based on real market fluctuations. Similar to the idea that past performance is not a decisive criterion for future yields, historical volatility provides little information about expected risk. In this case, implied volatility makes a much stronger statement. It draws on the Option Pricing Theory by Fischer Black and Myron Scholes. Because the model’s other parameters, such as the price of the base value or the risk-free interest rate, are easy to ascertain, the market’s volatility can be forecasted based on the option pricing for supply and demand shown on the Eurex derivatives exchange. Its high liquidity and the large number of market participants, especially in terms of papers for well-known indices, make option handling a reliable indicator for market forecasting. Additionally, implied volatility is characterized by strong, negative correlation to the respective stock markets. Thus, it immediately reacts to market events and, for example, increased dramatically in fall 2008 during the height of the financial crisis.

Read more: Volatility measures market risk