The wild swings in the stock market this week have sent market volatility levels to heights not seen since the financial crisis.
Volatility can sound scary, but it's a natural part of any market. Here's a breakdown on how it works:
WHAT IS VOLATILITY?
In the simplest of terms, volatility is how dramatically a market moves from one day to another.
A trader once described market volatility as like the turbulence that can hit an aircraft. An airplane might be trying to get from 35,000 feet to 30,000 feet, but turbulence will cause the plane to move up or down a few hundred feet, or rock left to right, on its way there. The higher the volatility, the rockier the passengers' ride is from point A to point B.
WHY DOES VOLATILITY HAPPEN?
First of all, volatility is not good or bad, it's just another way to describe how the markets are performing.
But more often than not, heightened volatility happens at times of uncertainty in the financial markets. When traders have reason to be worried, they might sell or buy a stock in larger amounts than usual, causing the company's stock price to whipsaw around.
HOW DOES WALL STREET MEASURE VOLATILITY?
There are a few measures, but the most quoted one is the Chicago Board Option Exchange's Volatility Index, most often called the VIX. The VIX essentially measures how volatile that investors expect the market to be in the next 30 days. The higher the reading, the more volatility expected, but a reading of above 30 points is generally considered a sign there's a lot of fear in the market.
The VIX hit a record of 80.86 at the height of the financial crisis. It has mostly remained below 20 for the last few years, with occasional but fleeting surges higher.
SO WHERE DOES THE VIX STAND NOW?
The recent shakeout of the financial markets has sent the VIX surging. It traded as high as 53.29 Monday, a level not seen since 2008-2009. The index has pulled back significantly from those levels, closing at 30.32 on Wednesday.
WHAT HAPPENS NOW? DOES IT AFFECT MY 401(K)?
If financial markets continue to make these large swings up and down, the VIX will remain elevated and it will be a sign that traders are uncertain on where the stock market is going next.
Typically an average investor does not own the VIX outright, although options and futures contracts on the gauge are traded. But it can be a sign that investors should be braced for wild swings in their account balances going forward. Also volatility is a very short-term phenomenon, and over the decades' long life of a retirement account, its impact is minimal.