The index measures the market’s expectation of future volatility. Based on options of the S&P 500® Index, the CBOE VIX index is widely used in the U.S to gauge the market volatility.
So why do you need this in your portfolio, and why is it different from volatility?
As discussed in my previous post, volatility is ex-ante. On the other hand, the Vix index uses options of the S&P 500® Index to calculate the market’s expectation of future volatility. The Vix index is a leading indicator.
Click on the image below to view the interactive dashboard.
The price of a security does not go up in a straight light. You may feel like you are on a rollercoaster. All your emotions are running wild the stock you bought is heading a different path to your expected path. Ah! this is the volatility I write about.
The prices swing up one day then down two days. Then you all reasoning is thrown out the window and you decide to close the positions that are causing you stress.
What is the measure volatility?
It is the standard deviation of the log returns on your portfolio, a stock price, an index or any financial instrument.
This is quite useful to understand the behavior and risk of an instrument. With this, you can calculate the expected return of a stock or portfolio.
View the code below to see sample calculations of a portfolio calculation in python. I have used data from yahoo finance. Please download the data if you wish to follow.
You have some spare money and are excited! You want to make this money work for you but you hear all the talk of a bubble coming soon you are worried. What will happen if you invest the spare cash? Will you make some money or will you lose it! This is uncertainty, this is a risk.
Risk is uncertainty. Uncertain your portfolio will return a profit. Risk is a very important topic in the financial markets and in the business world at large. Some risks are listed here.
Foreign exchange risk
and many more…
When building your portfolio you need to be aware of the risks that affect the assets in your portfolio.
When managing a portfolio the quantifiable risk, volatility is the standard deviation of the portfolio return.
When analysing stock you have to remember that this is a time series. What this means is that you can carry out analysis on different time windows.
For example, Analysis of the daily return for one year, analysis of monthly return of one year or yearly return over 5 years.
How do we measure risk one way to measure risk is by using volatility.
To understand what a portfolio is please read my article here.
What is Sharpe ratio? It is a measure that adjust returns for risk. It enables you in a quantitative way to chose between two or more stocks.
Why and when will you need to use it? The simple answer to this is, if you are building a portfolio and are looking at instruments which seem to have the same performance, for example they rise 2% each month. You only have money to select three out of twenty such stocks what do you do?
Well one of the measures you can use is the Sharpe ratio developed by William Sharpe. This takes into account the volatility and risk free interest.
Historically, risk-free rate used for the calculation, were for example LIBOR and 3 month T-bill (90days). In more recent years this is set to 0%.
The Sharpe ratio can be viewed as return vs risk ratio i.e. how much risk was taken to obtain the return.
A high Sharpe ratio with a high portfolio return shows return to risk ratio was low
A Low Sharpe ratio with a high portfolio return shows return to risk ration was high. So a lot of risk was taken.