At the heart of all trading and investing strategies are methods of dealing with volatility. Volatility is inevitable, but it’s impossible to know whether it’s a warning sign of a shift in a stock’s primary trend or whether it’s just random and meaningless.
Volatility can knock you out of good positions, but it can also present great opportunities to add to your favorite stocks.
Volatility comes into play in two ways
First, it helps in determining the right places to make stops. Underestimating routine volatility will keep you stopped even though conditions aren’t really changing. If you overestimate volatility, you will suffer larger losses when a stock’s trend actually changes.
The second way volatility comes into play is that it offers good short-term trading opportunities. Upside volatility offers the potential for a quick flip and remount at a lower price. Downside volatility can present a good opportunity to increase position size in a preferred name.
The first step in dealing with volatility is getting a sense of what a normal level is. This is very difficult as it depends not only on the specific stock but on the general market conditions. Normal volatility levels will constantly expand and contract.
How to measure volatility
One way to measure volatility is to look at how much a stock is moving relative to a benchmark like the S&P 500. A stock with the same level of volatility as the S&P would have a beta of 1, but a stock like Tesla (TSLA) moves much faster in either direction. Currently, Tesla’s beta is around 2.1, using monthly data for the last five years. That means we can expect Tesla to move about twice as much as the S&P 500.
Knowing a stock’s beta can be very helpful in setting stops at levels so you don’t get rocked by routine volatility. They can be found on Yahoo Finance and many other places.
Aggressive traders tend to favor higher volatility stocks simply because they are likely to generate much better returns if you pick the right ones. Of course, this also means that bigger losses are possible if you have the wrong name.
Managing volatility in small-cap or high-beta stocks is an art form. If you play it wrong it will destroy a good trade, but if you get it right it can improve your returns.
My approach to dealing with high volatility stocks is to use an incremental trading approach. I want to buy and add to positions on downside volatility and then sell on upside volatility. The tricky part is that if volatility doesn’t reverse after your move, you’ll need to reevaluate your strategy and decide whether to take a loss if the decline continues or chase positive momentum if a stock continues to rise. I deal with this by holding positions with different time frames and different stops and buy levels.
A mistake many traders often make is that they are always looking for an explanation as to why a stock might be moving. Often there is no essential reason. It can just be market conditions or seller moves that have nothing to do with a stock’s merits.
The best step you can take is to consider volatility before entering a trade. Quite often a stock will immediately move against you for no good reason. If you plan this ahead of time, volatility will be your friend rather than your foe.
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