What is volatility?
Volatility is a measure of the degree to which the price of a financial instrument fluctuates over a given period. It captures the magnitude of price changes, and sometimes their frequency, and is one of the primary measures of risk used in financial markets. A financial instrument with high volatility experiences large price movements, sometimes clustered in short periods, while one with low volatility moves within a narrower range over a comparable time horizon.
Volatility is typically measured using standard deviation, a statistical measure of how much a series of returns deviates from its average. In financial markets, volatility is generally calculated from historical price data, which is known as realised or historical volatility, or derived from the prices of options on the instrument, which is known as implied volatility. Implied volatility reflects market participants' collective expectation of future price movements.
Volatility is driven by surprise: the gap between expectations and outcomes. Both expected events, such as corporate earnings announcements, central bank rate decisions, and scheduled macroeconomic data releases, and unexpected events, such as geopolitical shocks or credit events, can generate volatility. What matters is whether the outcome differs from what was already priced in. An earnings release that comes in close to consensus typically produces little movement; the same release delivering a large upside or downside surprise can produce a sharp repricing.
What does volatility mean for the markets?
Realised volatility describes what actually happened; implied volatility reflects what the market expects to happen.
Volatility has direct implications for market makers and for all other market participants. For market makers, higher volatility affects two distinct risks. The first is inventory risk: positions already held on the book can move sharply between the time they were acquired and the time they can be hedged or unwound. The second is adverse-selection risk on live quotes: the risk that a faster or better-informed participant trades against a quote before it can be updated. When adverse-selection risk rises, market makers may widen their bid-ask spreads to compensate, which raises the cost of execution in the affected instruments.
Volatility is also a critical input in the pricing of derivatives, particularly options. The higher the expected volatility of the underlying instrument, the more valuable an option becomes, because a larger potential price movement increases the probability that the option will expire in the money. This relationship is formalised in standard options pricing models.
Example Volatility
Suppose a market maker is quoting options on a major European equity index. In a stable market environment, it calculates an implied volatility of 15% and quotes options accordingly, with relatively narrow bid-ask spreads. A central bank interest rate decision is then announced at a level clearly different from what had been priced into markets. The index moves sharply and realised volatility spikes to 35%. The market maker updates its theoretical prices to reflect the higher implied volatility. It also widens its quoted spreads on options most exposed to further moves, reflecting the higher risk of being picked off before it can update again. An investor looking to buy a one-month at-the-money call option will now pay a significantly higher premium than before the announcement, directly reflecting the market's revised expectation of future price movements.
For more on how options and other derivatives are used to manage exposure to price movements, see our explainer on Hedging.
