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What is Volatility and why is Brexit Causing It?

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If it just so happens that you have not caught up on the news in the past few days, well, you’re going to be in for a surprise. Great Britain shocked the world and voted to leave the European Union by a very close vote of 51.8% to 48.2%. It’s quite telling that the markets were only pricing in about a 25% chance that Britain would vote to leave the European Union, per a report from Time Magazine. It isn’t surprising that Wall Street, once again, drastically misinterpreted the desires of Main Street. Markets in the past few years have had a difficult time predicating the will of the people, both in Europe and in the U.S.

Whether or not global markets are capable of forecast populism, it does not change the fact that Britain’s departure from the EU can have devastating effects. Not only is most ambitious experiment of benevolent globalism arguably the on the brink of collapsing, stocks are down worldwide, the British Pound has plunged, and we have now entered the realm of volatility. This may be the beginning of the larger market correction.

So what exactly is “volatility” in the context of the market? Volatility is a statistical measure of the dispersion, or the size of the range of values expected for a particular variable, of returns for a given security or market index. Volatility can either be measured by using the standard deviation, which is the figure that measures the dispersion of a set of data from its mean (the higher the number, the more spread-apart the data is), between returns from that same security or market index.

In layman's terms, volatility refers to the amount of uncertainty or risk about the size of changes in a security (market, stock, ETF, etc.). A higher volatility suggests that a security's value has high fluctuations, meaning that its price can change dramatically over a short time period either positively or negatively. A lower volatility suggests that a security's value has low fluctuations, meaning that its price changes in value at a steady pace over a period of time.

Market volatility is measured by the the CBOE Volatility Index and the S&P 500 VIX Short-Term Futures ETN (VXX - Free Report) . To help contextualize volatility, VIX is up a staggering 35.65% as of 2:06 PM ET, VXX has skyrocketed up 22.42% as of 2:22 PM ET, and the British pound is down 8.86% as of 2:23 PM ET.

So how does the “Brexit” create volatility in the global markets? The answer is one word – uncertainty. The results of yesterday’s vote generate more questions than they answer: Does Britain leaving create a ripple effect? Will other members of the European Union also leave? Is France next to go? What about Spain? Will this affect Germany’s financial influence in the region? Will the EU simply disintegrate and become a blip in history?

There are simply too many questions that do not have answers. Too much uncertainty scares people and investors, and scared investors do not invest whatsoever, i.e. a perfect recipe for market volatility.

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