Volatility is a measure of the degree of price fluctuation and this is a non-directional parameter. Historical volatility is the range that prices have traded over a given period in the past, and it gives us an idea of how price behaved under known market conditions. Implied volatility is the market’s view of the expected trading range over a given period in the future, and this is not a static number but one which continually changes to reflect the market’s view.
Advantages and disadvantages of asset price volatility
If the price of an asset exhibited zero volatility, there wont be any opportunities to make a profit since the price would be static. There, an advantage of price volatility is that it provides us with opportunities to profit. The greater the volatility, the larger the potential profit. Volatility is also associated with faster profits. Market participants also tend to learn the required lessons much more quickly with volatile stocks compared to stable stocks. There is little to learn from looking at a very slow and steady stock, and if you do any learning from that it takes a long time to do so.
Price volatility also has disadvantages. It’s non-directional nature means that it works both ways. While it provides the opportunity for large profits, it also provides the risk of equally large losses. Losses of 50%-90% are not unusual with volatile stocks.
Measuring asset volatility
A common way of measuring price volatility is the standard deviation from the mean price for a given time period. Alternatively, the width of Bollinger bands can be used (a wide band would indicate high volatility). Others assess volatility using the maximum drawdown (the largest price drop from peak to trough over a specific time period). Beta is an alternative way of expressing volatility but this is in relation to another asset or index.
Gold and silver volatility – Bollinger band width
The above chart of gold on the monthly scale includes volatility according to the Bollinger band width indicator. The highest volatility occurred in 1980, coinciding with the peak of the secular gold bull market. At that time, the Bollinger band width reached just under 2. Notice how all the all the peaks in volatility (indicated by vertical lines) are followed by a drop in the price of gold. The problem with using this as an indicator is that we don’t actually know how high the volatility is going to reach before it turns around when looking at it prospectively. Having said that, when this indicator reaches extreme levels, it would be worth becoming wary.
The above chart of silver on the monthly scale includes volatility according to the Bollinger band width. As with gold, the large peaks in volatility were associated with peaks in the silver price. This chart also highlights the imperfection of this indicator (note that ALL indicators are imperfect). In 2008 there was a spike in the silver price followed by a large price drop of 60%, but there was no associated peak in volatility.
In general we can conclude that major peaks in volatility tend to occur at the end of bull markets in both gold and silver.
Gold and silver volatility – Maximum drawdowns
The above chart shows the gold price during the 1970s bull market on the monthly scale. The percentage drawdowns that occurred along the way are labeled in purple. During the first leg of the gold bull market, and the drawdowns were relatively small (5-7%), subsequently increasing to approximately 13%, followed by 25-28% drawdowns. The primary bear market that followed led to a 48% drop in the gold price. In the second leg of the secular bull market, the drawdowns again were relatively low to start with, and subsequently increased to over 20%.
As shown in the above chart of the gold ball market of the 2000s, drawdowns were initially low (9%), and progressively increased (14-18%). As the bull market progressed, drawdowns of 25% and 34% occurred. The primary bear market that followed led to a 45% drop in the gold price.
Interestingly, during the 1970s silver bull market, the drawdowns were lower in magnitude than they were for gold. The first leg saw drawdowns of 12% and 17%. The second leg saw only one 20% draw down, followed by a 12% and a 14% drawdown.
It was quite a different story in the 2000s silver bull market, with three major drawdowns of 32%, 37% and 60%. That represents substantial volatility. The reason for the greater volatility of the silver price in the 2000s compared to the 1970s in uncertain but may relate to paper derivatives.
In conclusion, volatility tends to increase as the bull market progresses and it is normal to experience 20% -35% drawdowns or corrections. Experiencing a 35% drop in an asset price can be traumatic for some, particularly for those who entered at the preceding peak in price. Price volatility is a normal part of bull markets and should be anticipated. Bull markets can shake people out and it is not as easy to profit from them as many people think.