Understanding volatility and risk

In the world of finance, one definition of ‘risk’ is the likelihood that you’ll lose some or all of the money you put into a trade or investment. That risk comes from selling an asset at a lower price than you paid for it.

Derivatives trading introduces more risk to your portfolio in a number of ways – one being rapid losses if a market moves in the opposite direction to your trade (eg if you take a long position and the stock then decreases in value and vice versa).

When you want to take a position on a particular asset, you should first do some research and analyse the asset carefully to get an idea of which direction it may take in the short term.

However, the financial markets can be quite unpredictable. The price of the asset you’re trading could move in either direction – regardless of what your research and analysis tell you. If this happens, you could potentially lose all your capital, depending on the extent to which the market has moved against you.

Volatility is closely tied to risk. It relates to the size of price fluctuations for a particular asset over a period of time. The higher the levels of volatility, the higher the risk. Volatility is caused by supply and demand in the market. Each time a share is bought or sold in the market, its price can change. High demand for a share pushes its price up, and low demand or many people selling at once pushes it down.

If many traders buy or sell shares from a single company at the same time, the price fluctuates more as every participant opens or closes a trade. How you perceive this volatility depends on the specific timeframe you’re looking at.

Simply put, if you watched every single transaction made on a particular share by the second, a chart representing all these small changes would make it appear extremely volatile. But if you tracked the price of the same share over, say, a ten-year period, it would look like a more stable movement towards today’s price.

The risks of trading vs investing

Just as we put money into a savings account to benefit from the interest accrued over time, we invest in shares because we hope the value of a company will rise over time. Additionally, some investments pay dividends periodically.

You can think of long-term share investments as a large boat that can withstand choppy waters. You’ll still feel the waves, possibly get slightly seasick and sometimes even get a few splashes of water when the tides are rough. But overall, you’ll stay relatively dry.

However, that doesn’t mean that investing in shares comes without risk. For instance, if the price of a share you own goes down and you decide to sell it, you risk losing some or all of the money you paid for it.

Derivative products, on the other hand, allow you to take advantage of price fluctuations. In a liquid market, these changes happen by the second, which presents you with the opportunity to make money in a short space of time. But this also means you could lose your capital fast.

Remember, you don’t have to take ownership of an asset when trading derivatives like you do when you hold shares. Instead, you’re buying a contract that allows you to take whatever profit or loss a share makes in the time you’re holding that contract.

Derivative products also allow you to pay a deposit (or margin) for the contracts you want to hold instead of putting up the full share price. You can find out more about margin, leverage and derivatives trading in our course ‘How spread betting and CFD trading work’.

Let’s use an example to put what we’ve learnt above into perspective.

Say ABC Ltd is listed at 100p per share. The company has had huge success over the years and this caught your attention, so you decide you want to invest £1000 of your money in it.

If you open a conventional trade with a stockbroker, you’ll be able to buy 100 shares with your capital (ignoring commission and other charges). If the company’s share price goes up by 20p, your investment will be worth £1200.

If instead the shares drop by 20p each, your shareholding will then be worth £800.

On the other hand, if you open a trade using leveraged derivatives, you’ll only need to put up a fraction of the cost as your initial outlay.

For instance, if your provider has a 10% margin requirement on the same shares, you’ll only need to pay £100 to open the trade.

As you’ve seen from the above exercise, derivatives trading may offer greater profits in a shorter period, but it also introduces more risk than share investing. Not only is it harder to predict short-term changes in a share’s price, but you can also lose more money than you initially put in.

If a share investment is a large boat, a derivative product is a jet ski. It goes much faster, but you’re much more likely to get wet.