Are You Prepared for Market Volatility?
Is volatility rocking your trading game or does it make you excited? Just what is volatility and how can you put it to your advantage?
High volatility is associated with uncertainty and risk. And when it’s high, there’s potential for big price swings. I embrace high volatility for the stocks I trade… and I can teach you to do the same.
Market volatility — it’s one of those stock market terms that can strike fear in the hearts of some traders. For others, it brings feelings of anticipation and excitement.
It’s discussed by the talking heads on financial news channels. It’s cursed by investors who fail to see it coming. And it’s written about in academic papers.
If you’ve been following the markets this year, you’ve heard the term volatility a lot. Get used to it…
A recent CNBC article called 2018 the most volatile year on record. (Check out that video — the Credit Suisse strategist predicts that market volatility will continue.)
What do I think? I’m not making any grand predictions, but I’ll say this:
I embrace high volatility for the stocks I trade.
And I teach my Trading Challenge students to do the same. But it can be unnerving if you’re a newbie.
Recently the market has had a fair number of volatility spikes, so here’s a primer to help you keep your cool when things get rocky.
What Is Market Volatility?
To understand market volatility and how it can work for you as a trader, first you need a basic definition:
Volatility is a statistical measure of the gap between low and high prices of a stock.
In other words, it’s a measurement that accounts for the stock’s price range — usually over time and in relation to current price.
For overall market volatility, you make a similar calculation using one of the major stock indexes, like the S&P 500.
I’ll give you a formula to calculate volatility later in this post.
How Are Volatility and Risk Related in an Investment?
According to Investopedia, “volatility refers to the amount of uncertainty or risk related to the size of changes in a security’s value.”
In layman’s terms, that means volatility increases when there’s uncertainty — that brings a risk of bigger price movements.
I like that.
Financial experts often refer to the VIX, a market volatility index.
Created by the Chicago Board of Options Exchange, it uses call and put options to measure future bets on individual stocks and the market as a whole.
While that sounds complex, think of it as a way to forecast market volatility.
What Does High Volatility Mean?
High volatility means the range between upper and lower prices is high…
When buyers outnumber sellers, high volatility sends the stock price higher.
When there are more sellers, high volatility sends the price of the stock lower.
Both moves are examples of supply and demand combined with high volatility.
Benefits of Trading in High-Volatility Markets
I love trading high-volatility penny stocks. My trading strategies depend on high volatility.
What is volatility trading?
It’s planning your setups based around high volatility. While volatility isn’t the only factor, without it the percentage or price movements aren’t big enough to interest me.
Big movements in volatile markets mean I don’t have to get in and out at the very bottom or top of the price move for the trade to be successful…
I can wait for confirmation (although sometimes it’s not much of a wait!) before I get in.
Because I tend to trade conservatively, I get out when the trade hits the exit point outlined in my trading plan.
At the very least — I close out enough of my position to protect profits and let the rest ride.
How to Calculate Volatility of a Stock
There’s more than one volatility calculation out there — meaning it can be a little subjective. The classic measure is called standard deviation.
Because I’m interested in volatility as it relates to price swings, I’m going to show you how to calculate volatility a different way first.
I’ll use the average true range (ATR) method.
(Pro tip: Add an ATR indicator on most stock charting tools — so you won’t need to do these calculations yourself.)
- Calculate the true range (TR) for one period. The TR is the difference between the high and the low. Here’s a simple example: A stock’s daily high was $10, and the low was $6. The true range is $4. (10﹣6 = 4). The standard number of periods to calculate the ATR is 14, but for simplicity we’ll use only three.
- Let’s assume the three daily TRs are $4, $3, and $4.25. Now find the ATR: (4 + 3 + 4.25) ÷ 3 = 3.75.
- Next, use the ATR to calculate volatility as a percentage of price. Say the stock’s current price is $14. Divide the ATR by the current price and state it as a percentage: 3.75 ÷ 14 = .27 or 27% volatility. (This is super high volatility! You won’t find many blue chip stocks even close to this.)
Market Volatility Formula
This is one of those times I’m going to tell you to do your homework and point you in the right direction.
That’s because I could write five posts just on different types of volatility. Seriously!
However, I will give you the standard deviation formula so you can see how it works:
Imagine you have three closing prices of $12, $14, and $16.
- Find the average: (12 + 14 + 16) ÷ 3 = 14
- Calculate the deviation by subtracting the average value from each day’s close:
12﹣14 = -2, 14 － 14 = 0, and 16﹣14 = 2. You get ﹣2, 0, and 2.
- Square the deviations and you get 4, 0, and 4.
- Add the squared deviations: 4 + 0 + 4 = 8
- Divide by the number of data values (three trading days in this example): 8 ÷ 3 = 2.66.
- Find the square root of the variance: The square root of 2.66 = 1.63… that’s the standard deviation.
Standard deviation is used by many institutional investors to calculate volatility and risk. It gives traders an idea of how far prices might swing from the average.
The Bottom Line
Are you ready for my daily mantra? Keep studying. Study hard. Build your knowledge.
Volatility in the overall market can affect other markets — so pay attention!
Now that we have covered the basics of what volatility is and how it can affect trading, we can finally review some trading tips to take advantage of these conditions.
In tomorrow’s issue, I will reveal my top 8 tips for trading in unpredictable markets and how to navigate them successfully.
— Tim Sykes
Editor, Penny Stock Millionaires