Making Money in a Volatile Markets
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.
I embrace high volatility for the stocks I trade.
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 cover both of those formulas in a minute…
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, and so should you.
To determine volatility, 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. (Seems simple, right?)
When buyers outnumber sellers, high volatility sends the stock price higher.
When there are more sellers than buyers, 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.
In fact, my trading strategies depend on high volatility.
So, what is volatility trading, and how do you take advantage of it?
It’s all about 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.
The ATR Method
This is 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, but you should know the math behind it anyway.)
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)
Usually, the standard number of periods to calculate the ATR is fourteen, but for simplicity we’ll use only three.
Let’s assume the three daily TRs are $4, $3, and $4.25.
Now find the average true range (ATR):
Take all your TRs, and get the average.
Again, usually you would use fourteen days worth of information, but for simplicity we are only using three.
($4 + $3 + $4.25) ÷ 3 = $3.75
Use the ATR to calculate volatility as a percentage of price.
Let’s 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.)
The Classic Method
This is the most commonly used method by traders. Both calculations are useful tools, but I find the first one to be more helpful.
Imagine you have three closing prices for a stock of $12, $14, and $16.
Find the average
($12 + $14 + $16) ÷ 3 = $14
Calculate the deviation
To find the deviation, you subtract the average value from each day’s closing price:
$12 – $14 = -2
$14 – $14 = 0
$16 – $14 = 2
You get ﹣2, 0, and 2.
Square the deviations
That will bring your values to 4, 0, and 4.
Even if the deviation you got in the last step is negative, squaring it will leave you with a positive number.
Add the squared deviations
4 + 0 + 4 = 8
Divide by the number of data values
8 ÷ 3 = 2.66.
Again, typically you would use more than three data values, but for this particular example I wanted to keep the math simple.
Find the square root of the variance.
The square root of 2.66 = 1.63
That’s gives you 1.63 for 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
I could write five posts just on different types of volatility. Seriously!
It plays a massive role in the way I trade and the stocks that I invest in.
If you know how to leverage volatility, you can use it to boost your trading to the next level.
But there’s a catch…
Are you ready for my daily mantra?
Study. Study hard. Keep studying. Build your knowledge.
You can’t expect to make volatility work for you, unless you are willing to put in the hours, and the research.
If you do, it will make you wildly successful. The more you learn the better you will become and the more you will make.
I look forward to seeing you at the top with me.
Editor, Penny Stock Millionaires